Key Takeaways
- Index funds track a market index rather than trying to outperform it.
- Because they require minimal active management, index funds typically carry lower fees than actively managed funds.
- Broad index funds offer built-in diversification across many companies and sectors.
- Historical data shows most actively managed funds underperform their benchmark index over the long term.
- Index funds are available as mutual funds or ETFs, each with slightly different trading rules.
- This article is general financial education, not personalized investment advice.
Index Fund
An index fund is a type of investment fund designed to mirror the performance of a specific market index, such as the S&P 500. Rather than having a manager handpick stocks, the fund simply holds the same securities as the index it tracks. This approach is called passive investing because it follows a preset rule rather than making active trading decisions.
Index funds can be structured as mutual funds or exchange-traded funds (ETFs). Their defining feature is a rules-based methodology that replicates a benchmark index by holding its components in proportion to their weight in that index.
How Index Funds Work
A market index is a standardized list of securities that represents a segment of the financial market. The S&P 500, for example, tracks 500 large U.S. companies. An index fund holds those same securities in roughly the same proportions, so its performance closely mirrors the index.
Because the composition of the fund is determined by the index's rules — not by a portfolio manager's judgment — trading activity inside the fund is minimal. The fund buys or sells holdings mainly when the index itself changes, such as when a company is added or removed. This rules-based approach is the foundation of passive investing.
To understand how this compares with funds that do rely on active stock selection, see our breakdown of active vs. passive investing.
~90%
Active U.S. equity funds that underperformed their index over 20 years
According to S&P Dow Jones Indices' SPIVA U.S. Scorecard, roughly 90% of actively managed large-cap U.S. equity funds underperformed the S&P 500 over a 20-year period.
0.03%–0.20%
Typical expense ratio range for broad index funds
Index funds frequently carry expense ratios well below 0.25%, compared to the industry average for actively managed funds, which often exceeds 0.50%.
$10T+
Assets tracked passively in U.S. funds
Morningstar data has shown total passive fund assets in the U.S. surpassing $10 trillion, reflecting substantial growth in index-based investing over the past two decades.
Why Fees Matter So Much
One of the most cited advantages of index funds is cost. Because there is no team of analysts researching individual stocks, the fund's operating expenses — expressed as an expense ratio — tend to be far lower than those of actively managed funds.
That difference may sound small in percentage terms, but it compounds meaningfully over time. A 0.70% annual fee difference on a $50,000 portfolio held for 30 years can translate into tens of thousands of dollars in reduced returns, depending on market conditions. Our explainer on investment fees walks through how those numbers add up in practice.
Check the Expense Ratio Before You Invest
Before choosing any fund, look up its expense ratio in the fund's prospectus or fact sheet. Even a difference of 0.50% per year can compound into a substantial drag on long-term returns. Lower is generally better when comparing funds that track the same index.
The Case for Passive Investing
The rationale behind index investing draws on decades of academic research and market data. Studies from organizations including S&P Dow Jones Indices — which publishes its SPIVA (S&P Indices Versus Active) reports — have consistently found that the majority of actively managed U.S. equity funds underperform their benchmark index over 10- and 15-year periods, particularly after fees are accounted for.
This does not mean active management never adds value, or that index funds are the right choice for every investor. But it does explain why passive strategies have grown substantially in popularity among both individual investors and large institutions.
“Passive investing in low-cost index funds is one of the most powerful ways ordinary investors can participate in long-term market growth without paying heavily for the attempt to outperform it.”
— John C. Bogle, Founder of Vanguard Group and pioneer of the index fund for individual investors
Index funds also offer broad diversification by default. A single fund tracking the S&P 500 spreads exposure across 500 companies and multiple industry sectors, reducing the concentration risk that comes with owning only a handful of individual stocks.
Index Funds as Mutual Funds and ETFs
Index funds are not a single product type — they come packaged in two main formats. A traditional index mutual fund pools money from investors and prices shares once per trading day after markets close. An index ETF (exchange-traded fund) holds the same underlying securities but trades on a stock exchange throughout the day, much like an individual stock.
Both formats can track identical indexes, but they differ in trading flexibility, minimum investment requirements, and tax treatment. Our comparison of mutual funds and ETFs covers those distinctions in depth.
If you are new to investing altogether, our beginner's guide to investing explains how to think about account types and starting with smaller amounts.
This article is for general informational and educational purposes only and does not constitute personalized investment, financial, or tax advice. Investing involves risk, including the possible loss of principal. Consult a qualified financial adviser before making decisions about your own financial situation.