What Is an Index Fund? How It Works, What It Costs and the Risks

What Is an Index Fund?

An index fund is a mutual fund or exchange-traded fund (ETF) that aims to match the return of a market index. The US Securities and Exchange Commission’s investor site describes this as a passive strategy: the fund mainly invests in the companies that are in a chosen index, aiming for about the same return as that index before fees.¹

A market index is simply a list of investments with rules for what goes in it. The S&P 500, for example, includes 500 leading US companies and covers about 80% of the value of the US stock market.³ An S&P 500 index fund buys those companies in the same proportions as the index.

When you buy one share of an index fund, you own a tiny piece of every company in it. One purchase gives you a spread of hundreds or even thousands of businesses.

How an Index Fund Works

The fund follows the index automatically instead of relying on a manager’s judgment. When a company joins the index, the fund buys it. When a company leaves, the fund sells it.

Because there is no stock picking, an index fund trades less often than an actively managed fund. The SEC’s investor site notes that this can mean lower transaction costs, better tax results and lower fees.¹

Index funds come in two main forms. A mutual fund is bought and sold once a day at the closing price. An ETF trades on a stock exchange throughout the day, like a share. Both can track the same index.

Index Funds vs Actively Managed Funds

An actively managed fund pays professionals to choose investments they expect to beat the market; an index fund simply owns the market. The table below sums up the main differences.

The numbers favor indexing in most years. In 2025, 79% of actively managed US large-company stock funds did worse than the S&P 500, up from 65% in 2024, according to S&P Dow Jones Indices’ SPIVA report.⁴ The report adds that 2025 was the fourth-worst year for active large-company managers in its 25-year history.⁴

Why Fees Matter So Much

Every dollar paid in fees is a dollar that stops growing for you. A fund’s yearly cost is shown as its expense ratio: the share of the fund’s average assets used each year to pay its operating costs.² It appears in the fund’s prospectus.

The difference between fees of a few hundredths of a percent and 1% sounds tiny, but it compounds over time. The table shows an illustration: $10,000 invested for 30 years, with the investments earning 7% a year before fees.

These figures are an illustration, not a forecast; real returns vary from year to year. The point is the gap. With a 1% fee, nearly a quarter of the final balance in this example is lost compared with the cheapest option. Our compound interest calculator lets you test your own numbers.

What Index Funds Can Track

Indexes exist for almost every part of the market, so index funds come in many flavors.

• Large US companies: funds that track the S&P 500 or a similar large-company index.
• The whole US stock market: funds that hold thousands of companies of every size.
• International stocks: funds that hold companies outside the US, in developed or emerging markets.
• Bonds: funds that track an index of government or company bonds, usually steadier than stocks.
• Sectors and themes: funds that follow one industry, such as technology. These are narrower and riskier than broad funds.

Broad funds spread your money across the most companies. Narrow funds concentrate it, which can raise both the potential reward and the risk.

Index Funds vs Picking Your Own Stocks

Buying individual shares means betting on a few companies; an index fund spreads that bet across the whole market. If one company in an index fund fails, it is a small part of the fund. If it is one of five shares you own, it can wipe out a large part of your savings.

Picking stocks well also takes time, research and discipline. Professional managers with large research teams mostly fail to beat the index after costs, as the SPIVA figures show.⁴ For most people investing for retirement, owning the market is a simpler and cheaper starting point.

Some investors combine the two: a core of broad index funds, with a small share of their money in individual companies they want to follow. That keeps any single bad pick from doing serious damage.

Where Index Funds Came From

The first index mutual fund for ordinary investors launched in 1976. Vanguard’s First Index Investment Trust, now the Vanguard 500 Index Fund, let individuals buy a whole market index in one fund.⁵

The idea was simple: if most professional managers fail to beat the market after their costs, investors may do better by owning the market cheaply. Today index funds and ETFs are among the most widely used ways to invest for retirement.

The Risks of Index Funds

An index fund removes the risk of picking the wrong company, but not the risk of the market itself. When the market falls, a fund that tracks it falls too.

• Market risk: stock markets can drop sharply and take years to recover. An index fund will not avoid a fall.
• Concentration: some indexes are weighted by company size, so a handful of very large companies can make up a big share of the fund.
• No upside surprise: by design, an index fund will never beat its index. You get the market’s return, minus fees.
• Tracking difference: fees and trading costs mean a fund’s return will be slightly below its index.

These risks are why index funds suit money you can leave invested for years. Money you need soon, such as an emergency fund, is better kept in savings.

How to Choose an Index Fund

Start with what you want to own, then compare costs. Most beginners begin with a broad stock market fund and, if they want a steadier mix, add a bond fund.

1. Pick the index. Decide which market you want: large US companies, the whole US market, international stocks or bonds.
2. Compare expense ratios. Funds that track the same index can charge very different fees. Lower is usually better.
3. Check the minimum investment. Some mutual funds need a minimum to start; ETFs can usually be bought one share at a time.
4. Choose the account. Holding funds in a tax-advantaged account such as a 401(k) or an IRA can make a big difference over time.
5. Automate. Regular monthly investing keeps you buying through ups and downs, without trying to time the market.

Read the fund’s prospectus or fact sheet before investing. It lists the index, the fees, the main holdings and the risks.

A Worked Example: Investing $200 a Month

Regular investing in a low-cost fund shows how fees and time work together. In this illustration, someone invests $200 a month for 30 years, and the investments earn 7% a year before fees.

With a 0.05% yearly fee, the balance after 30 years is about $241,600. With a 1.00% fee, it is about $200,900. The person paid in the same $72,000 either way; the difference of roughly $40,700 comes entirely from fees and the growth those fees would have earned.

Real markets do not grow in a straight line, so the actual result would differ. But the gap between low and high fees shows up in almost every long-term comparison.

Index Funds and Compound Growth

Index funds work best when time does most of the work. Gains are reinvested, and those gains earn their own returns. Over decades this compounding can matter more than which year you started.

Staying invested through falls is part of the strategy. Selling after a drop locks in the loss and can mean missing the recovery. Our explainer on compound interest shows how reinvested growth builds over time, and our guide to inflation explains why cash alone often falls behind.

Building a Simple Portfolio With Index Funds

A portfolio can be as simple as two or three broad index funds. A common approach is to hold one fund for stocks and one for bonds, in a mix that matches how long you can leave the money invested and how much short-term ups and downs you can live with.

Stocks have more potential for growth but swing more. Bonds are usually steadier but grow more slowly. Someone decades away from retirement often holds more in stocks, while someone close to needing the money usually holds more in bonds.

Some investors add an international stock fund to spread their money beyond the US. Others prefer a single target-date fund, which holds several index funds and shifts the mix toward bonds automatically as the target year approaches.

Rebalancing: Keeping Your Mix on Track

Over time, the funds in a portfolio grow at different speeds, so the mix drifts away from what you chose. After a strong year for stocks, for example, a 70% stock and 30% bond mix might become 80% stocks and 20% bonds.

Rebalancing means moving money back to your chosen mix, either by selling some of what has grown or by directing new money to what has fallen behind. Many people do this once a year. It keeps your risk at the level you decided on, rather than the level the market happens to leave you with.

Index Funds, Dividends and Taxes

Many companies in an index pay dividends, and an index fund passes them on to you. You can take dividends as cash or reinvest them automatically to buy more shares, which adds to compound growth.

In a regular taxable account, dividends and gains from selling are usually taxed. Because index funds trade less than active funds, they tend to create fewer taxable gains along the way, one of the advantages the SEC’s investor site points to.¹ In a tax-advantaged retirement account, such as a 401(k) or an IRA, taxes are deferred or, in a Roth account, can be avoided on qualified withdrawals.

How your income is taxed depends on your bracket. Our explainer on how tax brackets work covers the basics.

What to Do After You Invest

The hardest part of index investing is often doing very little. Once your funds and contributions are set up, the main jobs are to keep investing regularly, review your mix once a year and avoid reacting to every market headline.

• Keep contributing. Regular deposits, even small ones, add up and buy more shares when prices are low.
• Check fees occasionally. Fund companies sometimes cut fees, and cheaper versions of the same index may appear.
• Review your goals. As your deadline gets closer, consider shifting more money toward steadier investments.

Common Myths About Index Funds

A few misunderstandings put people off index funds or lead them to expect too much.

• “Index funds are safe.” They are diversified, not risk-free. They fall when the market falls.
• “You need a lot of money to start.” Many ETFs can be bought one share at a time, and some brokers allow fractional shares.
• “All S&P 500 funds are the same.” They hold the same companies, but fees and trading costs differ.
• “Active funds always do better in a downturn.” Some do, many do not. Results vary from year to year.

Key Terms Explained

• Index: a list of investments, built by rules, used to measure part of the market.
• Passive investing: owning an index instead of picking individual investments.
• Expense ratio: the share of a fund’s average assets used each year to pay its running costs.
• ETF (exchange-traded fund): a fund that trades on a stock exchange throughout the day.
• Diversification: spreading money across many investments to reduce the effect of any one falling.

The Bottom Line

An index fund lets you own a whole market in one low-cost investment. Most active funds fail to beat their index after fees, which is why low fees and patience matter more than finding a star manager. Remember that an index fund still rises and falls with the market, so use it for long-term money. For more, browse our investing explainers.

Many people hold index funds inside a tax-advantaged account. Our explainer on Roth IRAs shows how that works.

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