Index funds can offer investors a way to diversify their portfolio and potentially achieve returns that can help them meet their long-term financial goals. Learn how index funds work and about their advantages and risks.
Index Funds: a Definition
An index fund is a type of fund, or basket of securities, that tracks a market index like the S&P 500 Index or the Nasdaq Composite Index with the goal of mirroring the returns. An index fund may be a mutual fund, in which case you would invest through a broker or the fund, or an exchange-traded fund (ETF), in which case you would buy shares over an exchange.1
How Index Funds Work
A market index is designed to measure a specific group of securities that represent a segment of the economy or sector of the market. For example, the Nasdaq Composite Index is an index that includes more than 3,000 stocks listed on the Nasdaq exchange, the majority of which are technology stocks. You cannot directly invest in an index because they are gauges, not securities.2
Index funds invest in a group of securities in proportion to a particular index to try to achieve its returns. Some index funds will invest in all the securities in an index, while others invest in a sample. Often, an index will base the weight of a particular security on the company’s market capitalization, which is the total value of its shares. In other cases, the price of the shares determines their weight.
Index funds typically invest with a passive approach, meaning that they do not trade securities often as they aim for achieving long-term results instead of outperforming the market. To achieve the right proportions, an index fund may use derivatives like options. The result is that investors have an indirect way to try to get the same returns as a market index.
Index Funds vs. Mutual Funds
An index fund can be a mutual fund, but it can also be an exchange-traded fund (ETF). A mutual fund is a company that pools money from investors to purchase a basket of securities like stocks or bonds. Investors may buy into a mutual fund to add diversity through the various securities, which can reduce risk. You can buy shares of a mutual fund through a broker or from the fund itself.3
Exchange-traded funds are like mutual funds in that they offer convenient diversification with a pooled investment. However, you buy and sell shares of ETFs through an exchange during the trading day, just as you would trade shares of stock.4
Whether they are mutual funds or ETFs, index funds have costs to consider. They usually have lower costs than actively managed funds, but not always. Fully understand a funds’ expenses before you invest because costs affect your profits.
Risks with Index Funds
Like with any investment, index funds do carry risks to consider. First, the returns of an index fund are not guaranteed to perfectly mirror the returns of the benchmark index. An index fund might invest in a sample of securities that are in the index, but the proportions may not be perfect. This is called a tracking error. As a result, an index fund may underperform the index.
An index fund may also underperform the index because of fees and expenses, such as trading costs, that cut into profits.
How to Invest in Index Funds
How you invest in an index fund will depend on whether it is a mutual fund or an ETF. You can buy shares of a mutual fund from the fund or through a broker. To buy into an ETF, you can simply buy shares through an exchange, as you would buy stocks.
Which index fund you may want to invest in will depend on a number of factors, including your investment goals. For example, an investor who wants to build wealth with a more aggressive strategy may want to invest in an index fund that tracks an index of technology stocks. A more conservative investor may want an index that tracks established blue-chip companies.
The Bottom Line
To learn more about whether an index fund may be right for your situation, consider consulting a financial advisor who can review the pros and cons for your specific situation. Before investing in any fund, be sure to read its prospectus carefully and fully understand all associated fees, costs, and risks.
Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
1 Investor.gov, “Index Funds.” https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-4
2 Nasdaq.com, “What Is the Nasdaq and What Companies Are in It?” https://www.nasdaq.com/articles/what-is-the-nasdaq-composite-and-what-companies-are-in-it-2021-05-12
3 Investor.gov, “Mutual Funds.” https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-1
4 FINRA, “Exchange Traded Funds and Products.” https://www.finra.org/investors/investing/investment-products/exchange-traded-funds-and-products