Index Funds: What They Are & How They Work (2024)

What Is An Index Fund?

An index fund is a mutual fund or ETF (exchange-traded fund) that tracks the performance of an underlying benchmark index. This means that, when an investor buys an index fund, they are buying a set of securities that represents a certain segment of the financial market.

How Do Index Funds Work?

For an investor who's interested in tracking an index, instead of holding dozens or hundreds of securities found in that index, the investor can buy shares of an index fund. The index fund buys and holds the securities in the index. This enables the investor to buy a large segment of the market through just one fund.

Since index funds are passively managed, the fund manager does not buy and sell the fund's investment securities at their discretion, as is the case with actively-managed mutual funds. Instead, the fund manager will only update the holdings whenever the index changes, which is infrequent.

Due to the low number of trades, and because there is no need to research and analyze securities, the operational costs of an index fund are extremely low. This is why index funds have such low expenses, which is a benefit to investors. The low costs also enable the index fund to tightly track the performance of the benchmark index.

8 Main Types Of Index Funds

Index funds have come a long way since 1976, when Vanguard launched the first publicly-traded index fund, which is now known as Vanguard 500 Index (VFIAX). Today there are so many types of index funds on the market that sorting through all the choices can be challenging for an investor.

And since the launch of the first exchange-traded fund in 1993,

, ETFs have made it possible for investors to buy stock-like securities that track a broad market index, plus a wider range of sectors and niche areas of the market.

Here are the main types of index funds on the market today:

1. Broad Market Index Funds: Among the most popular of index mutual funds and ETFs are index funds that track the major indices, such as the S&P 500, or what's considered to be a "total stock index," such as the Russell 3000 or the Wilshire 5000.
2. Market Capitalization Index Funds: Since many broad market index funds are heavily weighted toward large-cap stocks, investors can diversify with a small- or mid-cap stock index funds. Common examples of market cap benchmark indices include the Russell 2000 for small-cap stocks and the Russell Midcap Index for mid-caps.
3. Bond Index Funds: These fixed-income index funds may track a broad market bond index, such as the Bloomberg Barclays US Aggregate Bond Index, or a specific category of bonds like the S&P US Treasury Bond Index.
4. Tax-Free Bond Index Funds: Interest from bonds that are issued by municipalities may be tax-free to the investor. For this reason, some investors choose to buy a municipal bond index fund that tracks an index consisting of municipal bonds.
5. International Index Funds: Consisting primarily of non-US stocks, the most common international indices are the MSCI EAFE, which covers the developed regions of Europe, "Australasia," and the Far East, and the MSCI Emerging Markets Index, which covers 27 emerging-market countries, such as China, India, Russia, and Brazil.
6. Sector Index Funds: For investors wanting focused exposure to stocks within a specific sector of the economy, such as technology, health, financial services, real estate, or others, there are sector index funds that track an index for that respective sector.
7. Dividend-Focused Index Funds: These track indices of stocks of companies that pay either above-average dividends or they have a history of consistently increasing their dividends over time. Some dividend index funds may also focus on a sector or specialty type of stocks known for paying high dividends such as utilities stocks or REITs.
8. Socially Responsible Index Funds: A relatively new addition to the index fund universe, Socially Responsible Investing (SRI) index funds track a benchmark index representing stocks of companies with high governmental, environmental, and social standards.

Pros & Cons of Index Funds

Index funds provide many benefits to investors but like other investments types, there are some disadvantages to consider. It's important to understand the pros and cons of index funds before you add any of these passively-managed investments to your portfolio.

Pros of Index Funds

• Diversification: Rather than buying a single stock or bond, an investor can buy an index fund and gain exposure to dozens, hundreds, or even thousands of investment securities with just one fund.
• Low fees: Because index funds are passively managed, the operational costs are much lower, compared to actively-managed funds.
• Tax efficiency: Passive management generally translates to low turnover, or less trading, which then translates to less capital gains distributions to shareholders.
• Simplicity: Buying and holding a diversified basket of securities can be much easier than managing your own portfolio of stocks and bonds.
• Potential for superior long-term returns: While actively-managed portfolios may have greater potential to outperform the broad market indices in the short term, the majority of professional money managers do not outperform the market for periods of 10 years or more. This reflects a common buy-and-hold investor mantra, "if you can't beat 'em, join 'em."

Cons of Index Funds

• Lack of flexibility: Since index funds can only track the performance of the benchmark index, neither the shareholders, nor the fund management have control over the portfolio holdings.
• Vulnerable to market swings: Without the ability to adjust the holdings at their discretion, fund management can't use tactical methods to defend against extreme market corrections, nor can they take advantage of down markets to buy at lower prices. At times, this limitation can cause index funds to under-perform compared to actively-managed funds.
• Limited returns: Although some broad market index funds can outperform the majority of actively-managed funds, especially for time periods of 10 years or more, investors can never "beat the market" with a major market index fund. This is because they are bound to match the returns of the market index, less management fees.

How Do You Invest In Index Funds?

You can invest in index funds in the same way as other investment types, beginning with opening an investment account with a financial institution.

Here are the basic steps an investor can take to invest in index funds:

1. Choose a financial institution: Many investors use a discount online broker like Charles Schwab, TD Ameritrade, or E*Trade, while others may use a mutual fund company like Vanguard, Fidelity or T. Rowe Price. Investing apps, such as Robinhood, also offer index funds.
2. Open an account: You can invest in index funds in the main types of investment accounts, such as individual and joint brokerage accounts and IRAs. Many employer-sponsored retirement plans, such as 401(k)s, offer index funds as well.
3. Fund your account: Before you invest in an index fund, you'll need to add money to what is called a core account or settlement account. This is typically a money market account and can be funded easily online through ACH payment or electronic funds transfer.
4. Choose the index fund: Do your research and find the best index fund for your investment goals.
5. Buy shares of the index fund: Whether it's a mutual fund or ETF, the index fund will be identified with a ticker symbol. Many mutual funds have minimum initial investment amounts, typically ranging from $1,000 to $3,000. Index mutual funds can be purchased in dollar amounts or as a number of shares. ETFs can only be purchased as a number of shares, with 1 share being the minimum.

Are Index Funds a Good Investment?

If you ask an investment advisor, "Are index funds a good investment?", their first response will likely begin with two words, "That depends." This is because the answers to questions about the suitability of particular investment types are subject and unique to the investor's goals and tolerance for risk.

Index funds can be good investments for:

• Core holdings: When building a portfolio of investments, a broad market index fund can work well as a core holding, which means the investor will allocate a large percentage, such as 30-40% of your portfolio, to the index fund.
• Diversification: With broad market index funds, an investor can gain exposure to entire U.S. stock market, the entire U.S. bond market, and capital markets around the world.
• Tax efficiency: Since index funds are passively managed, there is very little trading necessary for the fund manager to maintain the holdings of the benchmark index. This decreases taxable distributions to index fund shareholders.
• Passive investment strategies: For the buy-and-hold or set-it-and-forget-it investor, index funds can be smart long-term holdings.
• Focused exposure to sectors: Some index mutual funds and ETFs track an index of a narrow area of the market, such as a sector or sub-sector of the economy like technology, health care, or real estate.
• Specific investment objectives or strategies: Whether you want to focus on dividend stocks, growth stocks, tax-free municipal bonds, defensive stocks, or socially responsible investments, index funds can be a convenient way to gain exposure to a particular investment objective or investment strategy.

Kent Thune