Index Fund

What is an index fund?

An index fund is a mutual fund or exchange-traded fund (ETF) that buys all the investments in a market index, so its performance follows that index instead of depending on a manager choosing winners. An index is simply a list of companies or bonds, like a list of the largest companies in the country. The fund owns what is on the list, in roughly the same proportions, and changes only when the list changes.

Key takeaways

• An index fund copies a market index instead of trying to beat it.
• One purchase can spread your money across hundreds or thousands of companies.
• Because nobody is paid to pick stocks, index funds usually charge lower fees than actively managed funds.
• You get the market's return minus a small fee, which means you also get the market's drops.

How an index fund works

The fund company chooses an index to track. It might follow large U.S. companies, the whole U.S. stock market, international stocks, or bonds. When you buy a share of the fund, your money is spread across everything in that index automatically.

Here is a hypothetical example with round numbers. Say you invest $1,000 in a fund that tracks an index of 500 companies. You now own a tiny slice of all 500. If one of those companies has a terrible year, it is only a small part of your $1,000, so your balance barely notices. If the index as a whole rises 10% over a year, your fund rises close to 10%, minus its annual fee.

That fee is the expense ratio. It comes out of the fund's value every year, so a small difference compounds over decades. Two funds tracking the same index can charge different fees, which is why comparing expense ratios matters more than comparing names.

Index funds come in two wrappers. An index mutual fund is priced once a day after the market closes. An index ETF trades on an exchange throughout the day like a stock. Both can hold the same investments. For a side by side, read the difference between index funds and mutual funds.

To see what steady contributions to a fund could grow into, try the compound interest calculator.

Why it matters for your Money Type

The Saver Money Type describes someone who is great at holding money but hesitates to let it work. The money is safe in savings, and investing stays on the "later" list while you look for the right choice.

An index fund takes away the hardest part of that decision. You do not have to pick the winning company or the best manager. You buy the whole list and let time do the work. Savers still need a clear safe number first, so keep your emergency fund untouched and invest only money above it. The Saver First Fix, Put It to Work, starts exactly there.

A Strategist usually already owns index funds. The question for them is less "should I" and more which indexes, in what mix, and inside which accounts. That is asset allocation.

Not sure which type you are? Take the Money Type quiz.

Common questions

Are index funds good for beginners?

They are one of the simplest ways to start because one fund gives you broad diversification and low costs. You still take on market risk, so they fit money you will not need for several years.

Can you lose money in an index fund?

Yes. An index fund rises and falls with the market it tracks, and it is not FDIC insured. A broad index fund would only go to zero if every company in it failed, but large temporary drops do happen.

What is the difference between an index fund and an ETF?

An index fund describes the strategy: copy an index. An ETF describes how the fund trades: on an exchange during the day. Many ETFs are index funds, and many index funds are mutual funds.

How many index funds do I need?

Many people start with one broad fund. Owning several funds that track overlapping indexes can mean owning the same companies twice without adding much diversification.