What Are Index Funds?

Quick Answer

Index funds are composed of a portfolio of stocks or bonds that follow a benchmark index, like the S&P 500, the Dow Jones Industrial Average or the Nasdaq Composite. Overall, they’re designed to match the performance of a specific market index.

african american man in business suit explaining index funds to man and woman couple

Index funds are investments that follow a benchmark index, such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq Composite. They're a type of mutual fund or exchange-traded fund (ETF) composed of companies that often share similar characteristics, such as size or industry focus. When you invest in an index fund, you are investing in all of the companies in that fund, which could be hundreds.

Index funds offer a great way for both novice and expert investors to benefit from the stock market's historical long-term growth while avoiding some of the risk and effort that comes with choosing individual stocks. Diversifying your investments by using index funds that follow an established benchmark can be part of a solid strategy to help you reach your financial goals.

How Index Funds Work

Index funds track the performance of a given stock index with the aim to have similar returns. For instance, if the S&P 500 experienced gains of 10% in a given year, an index fund based on the S&P 500 would ideally have similar gains—though returns are never guaranteed.

To achieve these results, the index fund will contain, to some degree, the same companies as the underlying index it's tracking. However, index funds create their own formulas for which companies to include and how much weight a given company holds in the fund, so an index may serve as more of a benchmark than an exact replication of a fund.

Index funds often track broad swaths of the stock market. Some of the indexes they track include the S&P 500, Russell 2000 and the Nasdaq, while others mirror the entire stock market. Here are four broad-based index funds that track some top indexes.

  • The Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX): Tracks the CRSP U.S. Total Market Index and provides exposure to the entire U.S. equity market, including small-, mid- and large-cap growth and value stocks.
  • The Schwab Total Stock Market Index (SWTSX): Tracks the Dow Jones U.S. Total Stock Market Index and features small-, mid- and large-cap U.S. equity securities.
  • Fidelity Small Cap Index Fund (FSSNX): Tracks the Russell 2000 Index and features small-cap U.S. securities.
  • Fidelity Nasdaq Composite Index Fund (FNCMX): Tracks the Nasdaq Composite Index and features both domestic and international stocks listed on the Nasdaq.

Pros and Cons of Investing in Index Funds

Index funds can be an excellent path into the world of investing, but you should know the advantages and disadvantages of investing in these funds.

Pros

  • Low cost: Index funds are passively managed, which means fund managers do not trade fund holdings as often as with actively managed funds. In turn, management fees, also called expense ratios, are lower.
  • Low maintenance: Instead of having to pick your own stocks, an index fund chooses stocks following a benchmark index.
  • Diversification: Investing in many companies included in an index fund can help mitigate your risk and balance your investments. Not all index funds are diversified, however; some may invest only in a certain industry or type of company, for example.
  • Less risk: Index funds tend to offer investors more stable, predictable returns over long periods of time than individual stocks and actively managed mutual funds. That said, returns are never guaranteed.

Cons

  • Slower growth: Gains may be slower than more aggressive investments.
  • Less control: Since an index fund follows existing stock indexes, you can't choose the companies included in the fund.
  • Possible high barrier to entry: Some index funds can require a sizable initial investment from $1,000 up to $100,000, though you can also find index funds that have no minimum investment requirement.

How to Invest in Index Funds

When it comes to choosing an index fund to invest in, a good approach is to look at your goals and where you are in your investing journey. Funds that track indexes containing global companies or high-growth stocks, like startup and tech stocks, could provide higher returns, but are more volatile. This might be ideal for those who have a higher tolerance for risk and a longer time horizon to invest. If you are looking for more stable, steady growth, you might consider funds that track indexes in more established sectors, contain more mature companies or are more broad-based.

You can invest in index funds a few ways. An employer-sponsored retirement plan such as a 401(k) may provide index funds you can invest in. If your employer doesn't offer a retirement plan, you can invest in index funds by opening an individual retirement account (IRA). You can also purchase index funds using an investment broker by opening an online brokerage account.

The Bottom Line

Because most of the research, management and administration is done for you, index funds can be a low-maintenance way to invest your money in the stock market. No matter which investing route you choose, consider consulting with a financial professional who can review your financial situation and recommend investments to help you meet your financial goals.

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