What Is an Index Fund & How Does It Work?

Investing in index funds has become increasingly popular in recent years. Investment research firm Morningstar reported in August 2021 that US stock index funds held $884 billion more in assets than active funds—and they continue to gain market share. Investing in index funds is a hands-off and passive approach that investors use to try and match, rather than beat, the market. Markets tend to rise over time, and index funds seek to capture those gains while holding down fees that tend to eat into returns.

What is an index fund?

“An index fund is a way to invest in every stock within a particular index or grouping,” explains John DeYonker, head of investor relations at Titan. These funds are either mutual funds or exchange-traded funds (ETFs), and their goal is usually to try to match the performance of a benchmark market index. In turn, a market index tracks a certain group of assets, such as stocks or bonds.

For example, the S&P 500 stock market index tracks 500 of the largest publicly traded US companies from leading industries. “You can't technically invest in the S&P 500,” DeYonker says. “That’s why you would need to invest in an index fund.” An S&P 500 index fund tries to mirror the S&P 500 index’s movement.

How do index funds work?

How an index fund works depends on who creates and manages the fund, and whether it’s a mutual fund or ETF. But the basics are often similar.

The fund pools money from investors, and the fund manager uses the money to try and replicate the benchmark index. There are funds for all sorts of market indexes, including stock (i.e., equity) indexes and bond indexes.

Index funds use a passive investment approach, meaning they simply try to mirror the changes in the chosen benchmark. Assets may be invested in the stocks and bonds that the benchmark tracks—or in a representative sample—and fund managers may buy and sell securities to try and move in tandem with the index.

Key things to know about index funds

• Index funds often have low fees.

  Many, but not all, index funds have lower fees than actively managed funds.  

• There can be tracking errors.

  Index funds aren’t always able to match their benchmark. When there’s a discrepancy between an index fund and its benchmark index, that’s called a tracking error.

• Index funds can make it easy to invest in the market.

  By choosing an index fund that mirrors a large stock market index, investors can easily invest in a stock market’s overall performance.

• Index funds mirror the ups and downs.

  While index fund investing is a popular hands-off approach, it isn’t without risk because it mirrors both the rising and falling price of its benchmarks. ‍

• Index investing can be simpler than picking stocks.

  For retail investors, using index funds may be an easier option than trying to buy and sell individual stocks or bonds.

Examples of index funds

Fund companies can create index funds to track a variety of benchmarks. These include broad stock market indexes, bond indexes, and indexes that focus on a specific region, industry, or other criteria.

These examples are just a small sample of the many types of index funds available to investors:

• Vanguard Total World Stock Index Fund Investor Shares (VTWSX).

  A mutual fund that tries to track stock market returns from around the world using the FTSE Global All Cap Index as a benchmark.

• Schwab S&P 500 Index Fund (SWPPX).

  A mutual fund that tries to track the total return of the S&P 500 index.

• SPDR S&P Dividend ETF (SDY).

  An ETF that tries to track the S&P High Yield Dividend Aristocrats Index, which looks for companies that consistently increase their dividends over time.  

• Fidelity U.S. Sustainability Index Fund (FITLX).

  A mutual fund based on the MSCI USA ESG Index, which tracks mid- and large-cap companies that rate well on environmental, social, and governance (ESG) metrics.

• Invesco California AMT-Free Municipal Bond ETF (PWZ).

  A municipal bond ETF that focuses on California municipal bonds that are exempt from the alternative minimum tax, or AMT. It tries to track the ICE BofAML California Long-Term Core Plus Municipal Securities Index.

Index funds vs. actively managed funds

Instead of index funds, some investors put their money into actively managed funds and ETFs. While index funds take a passive approach to investing by trying to mirror a benchmark, actively managed funds attempt to beat it.

An actively managed fund will often choose a market index as its benchmark. Then, based on research and analysis, fund managers look for investment opportunities either by finding undervalued shares or by timing the buying and selling of securities to beat their benchmark.

If fund managers outperform their benchmark, they’re “creating alpha” (expressed in return calculations as α), a term that describes how well an investment strategy performs relative to its benchmark.

Other things to consider

Beyond the approach and goal, there are a few things investors consider when comparing index funds to actively managed funds:

Fees

Fees can reduce the rate of return on an investment. When comparing investment options, investors may want to look at passive and actively managed funds’ total returns after fees.

Index funds tend to have lower expense ratios than actively managed funds. The expense ratios are shown as percentages and taken out of a fund’s assets by the fund manager.

According to the Investment Company Institute (ICI), an international association for regulated funds, the average expense ratio for index equity mutual funds was 0.06% in 2020. It was 0.71% for actively managed equity mutual funds.

The ICI found that index equity ETFs had a higher average expense ratio of 0.18% and index bond ETFs had an expense ratio of 0.13%. It didn’t report an average expense ratio for actively managed ETFs, but the vast majority of ETFs are passive index funds.

The actively managed funds’ higher fees are used to pay for the expertise and analysis that’s needed to continually research and act on investment ideas. Sometimes there are additional fees, such as account management and mutual fund load fees.

Performance

While fees can eat into returns, performance is also important. When comparing investment options, investors may want to look at passive and actively managed funds’ total returns after fees. While actively managed funds often have higher expense ratios, their overall performance may best passively managed funds—particularly for certain types of assets and over shorter timelines.

For example, during the year ended June 30, 2021, actively managed funds outperformed their benchmarks 41.8% of the time, according to S&P Dow Jones indices’s SPIVA research. And actively managed California municipal debt funds consistently outperformed their benchmark over one-, three-, five-, and 10-year periods.

But over a 10-year period ending on the same date, only 17.49% of actively managed large-cap funds outperformed the S&P 500.

Taxes

Investors who have taxable brokerage accounts may also want to consider the tax implications of index versus actively managed funds. Actively managed funds tend to produce more taxable gains than passive funds because the fund managers trade more often.

The bottom line

Index mutual funds and ETFs give investors a way to invest in different indexes. Investors can look for funds that track international markets, domestic indexes, specific sectors, or meet other criteria. The passive approach usually comes with lower fees, but it isn’t meant to outperform markets.

Actively managed funds often charge higher fees, but they also try to use their expertise to beat the market. Some actively managed funds are able to do this, and by doing so, increase the overall returns that their investors earn.