What are index funds?

Index funds are mutual funds or ETFs that are constructed to mimic the performance of a financial market index. There are a number of index funds that replicate the composition and performance of indexes like the S&P 500, the Russell 2000, the Bloomberg U.S. Aggregate Float Adjusted Index (a bond market index) plus a host of others across a wide range of investments. These include both domestic and international market indexes.

Index funds invest passively. In other words, the fund manager is looking to replicate the holdings that comprise the index and also to replicate the performance of the index. This is opposed to an actively managed fund that seeks to beat its benchmark index through buying and selling its holdings based on the fund manager’s analysis.

History of index funds

The first index fund was reputedly created by John McQuown, an institutional investment manager at Wells Fargo in the early 1970s.

The first index fund widely distributed to the general investing public was the Vanguard 500 Index Fund introduced in 1976 by Vanguard founder the late John Bogle. Vanguard has gone on to be one of the leaders in both index mutual funds and ETFs over time.

Over the years index funds have become an important part of the investing landscape for both individual investors and for financial advisors in managing their client’s portfolios. The first index funds were index mutual funds, but index ETFs have become a very popular investing vehicle for many individuals and professionals.

How does an index fund work?

Index funds are mutual funds or ETFs that seek to replicate the performance of a market index. For example, the ishares Russell 2000 ETF (ticker IWM) tracks the Russell 2000 index, an index of domestic small cap stocks. The goal of the fund manager is to invest in the stocks that comprise the index in the proportion those stocks are represented within the index.

Index funds are passive investments. They don’t try to beat the market or their underlying index, they invest passively in an effort to replicate the index’s performance. By contrast, an actively managed fund will buy and sell fund holdings on an active basis in an effort to outperform the fund’s benchmark. The fund managers will follow a strategy designed to deliver this outperformance that is often driven by detailed stock or bond research.

Types of indexes funds

Index funds track a wide range of indexes across stocks and bonds. They track indexes based on domestic and international holdings. They also track indexes in various subcategories of stocks and bonds such as small cap stocks or intermediate-term bonds.

Beyond the various investment asset classes and categories that various index mutual funds and ETFs might follow there are also variations in the way some indexes are configured.

Market-cap weighted index

A market-cap weighted index weights the holdings in the index by their relative value in the market. For example, according to Morningstar, the Vanguard Index 500 ETF (ticker VOO) top 10 holdings as of April 30, 2023 comprised 28% of the value of the fund’s assets at that time. Apple alone made up 7.22% of the fund’s value. Market capitalization for a stock is the price per share times the total number of shares outstanding. The performance of the largest holdings in the index can have an undue influence on its performance, good or bad.

Price-weighted index

A price-weighted index is one where the price of each holding determines its weighting in the index. Perhaps the most well-known price-weighted index is the Dow Jones Industrial Average. One problem with a price-weighted index is that the holdings in the index may need to be adjusted on a more frequent basis due to price fluctuations. This can come into play in a volatile market situation.

Equal-weight index

An equal-weight index is one where each holding is weighted the same regardless of its price of market cap. There is an equal-weighted version of the S&P 500 where Apple is weighted equally with the other 499 stocks in the index, regardless of their relative size.

Before investing in any index fund, be sure you understand how the components of the index are weighted within the fund.

Here are some examples of a few index mutual funds and ETFs and the indexes they follow.

Fund name	Benchmark index	Morningstar investment category
Fund name Invesco QQQ Trust (ticker QQQ)	Benchmark index NASDAQ 100 (a tech heavy index)	Morningstar investment category US Fund Large Growth
Fund name iShares Core MSCI EAFE ETF (ticker IEFA)	Benchmark index MSCI EAFE Investable Market Index	Morningstar investment category US Fund Foreign Large Blend
Fund name iShares Core U.S. Aggregate Bond ETF (ticker AGG)	Benchmark index Bloomberg U.S. Aggregate Bond Index	Morningstar investment category US Fund Intermediate Core Bond
Fund name Vanguard Growth Index Investor (ticker VIGRX)	Benchmark index CRSP U.S. Large Cap Growth Index	Morningstar investment category Large Growth
Fund name Fidelity 500 Index (ticker FXAIX)	Benchmark index S&P 500	Morningstar investment category Large Blend
Fund name Vanguard Total Stock Mkt Index Investor (ticker VTSMX)	Benchmark index CRSP US Total Market Index	Morningstar investment category Large Blend
Fund name Vanguard FTSE Emerging Markets ETF (ticker VWO)	Benchmark index FTSE Emerging Markets All Cap China A Inclusion Index	Morningstar investment category US Fund Diversified Emerging Mkts

These funds represent just a few examples of the index funds available to investors. This list should not be construed as any sort of recommendation.  

Index funds vs. actively managed funds

	Index Funds	Actively Managed Funds
Investing style	Index Funds Passive – The fund manager seeks to replicate the performance of the fund’s underlying index.	Actively Managed Funds Active – The fund manager is trying to outperform the fund’s benchmark and other funds in its investment category. The fund manager makes decisions to buy, sell or hold securities based on their research and other criteria.
Expenses	Index Funds Index fund expenses are generally low due to the fund’s passive investing style.	Actively Managed Funds Expenses are generally higher due to the need to perform research on stocks or bonds within the fund’s investing category.
Tax-efficiency	Index Funds Index funds are often more tax-efficient due to the requirement for fewer transactions based on the fund’s passive investing style.	Actively Managed Funds Active funds often generate more taxable distributions due to the higher number of transactions that generally occur in an actively managed fund as compared to an index fund.

Index fund pros and cons

Index funds have both several pros and cons.

Pros include:

• Index funds generally have lower expense ratios than actively managed funds. This is because the index fund managers are trying to replicate the composition and performance of the fund’s underlying index. 
• Index funds provide instant diversification to investors in terms of holding a number of different stocks or bonds, by providing diversification across the range of securities within the index.
• Index funds generally adhere to their investing style, making asset allocation decisions involving these funds easier.
• Many index funds offer solid long-term growth potential. It is not uncommon to see many index funds in the upper levels of performance for their investment category.

Cons include:

• Index funds will not outperform their underlying index. This is by design. For investors who are seeking to beat the market an index fund may not be the appropriate investment.
• There is little or no downside protection with an index fund. The funds will lose approximately the same amount as the underlying index in a down year.
• There is no investment flexibility with an index fund, the fund tries to replicate its index, period.

Frequently asked questions (FAQs) 

Are index funds good for beginners?

Index funds can be a very solid choice for beginning investors. They offer a diversified fund in terms of holding a number of securities inside of the fund based on the stocks or bonds that comprise the index.

Index funds make it easy to invest in well-known indexes like the S&P 500. Funds like a total stock market or total bond market index can simplify investing in a broad segment of the overall market in one fell swoop. Additionally, index funds are generally easy to understand and are often low cost investing alternatives. 

Is the S&P 500 an index fund?

The S&P 500 is not an index fund. Rather it is a market cap weighted index that tracks the 500 largest U.S. stocks. Standard and Poor’s is the company that manages the index and sets the parameters for stocks to be included as well as the frequency with which the index is updated or rebalanced.

An index mutual fund or ETF that tracks the S&P 500 is a fund that does its best to mirror both the holdings and the performance of the index. 

How much money do I need for an index fund?

For an index mutual fund, the amount of money you will need to get started is determined by the fund company. For example, the Vanguard 500 Index Investor (ticker VFINX) fund shows $0 minimum investment according to Morningstar. That is for this share class of the fund only, other share classes of the same fund, but with a lower expense ratio, do have minimum investment requirements.

When investing in an ETF, the amount needed to invest is a function of the share price of the ETF and number shares purchased. The share price can vary at any time during the trading day in the same fashion as the share price for a stock. For example, at the time of this writing the share price of the iShares 20+ Year Treasury Bond ETF (ticker TLT) was $102.00 according to Yahoo Finance. Besides the price per share, you may incur a transaction cost when buying some ETFs, this will depend on the broker you are using to make the purchase.