Index fund

An index is a list with a rule: which investments belong, and how much of each, published as one number that says how the whole list did today. An index fund buys the list, in the rule's proportions, and holds it. The fund's return is the index's return minus its expense ratio, in good years and bad, because nobody at the fund is choosing what to buy; the rule does the choosing, and a rule is cheap to run. That is the entire design, and it is why an index fund costs a small fraction of what a managed fund charges and why, over long periods and after fees, most managed funds have trailed the index they are measured against.

In a sentence

• "The whole 401(k) is in one index fund that tracks the S&P 500, and it costs 0.05% a year."
• "An index fund does not try to pick winners. It buys the whole market and keeps the fee small."
• "The index fell 20% that year, so the index fund fell 20% too, which is exactly what it is built to do."

How it works

1. An index is defined by a rule. An index such as the S&P 500 is a list of 500 large US companies, each weighted by its market value, so the largest companies are the largest holdings. Other indexes cover the whole US stock market, stocks outside the US, or bonds.
2. The fund buys the list. Money from investors buys every holding in the index in the index's proportions, and the fund's value is the value of those holdings.
3. The holdings change only when the index does. When a company is added to or dropped from the index, the fund follows. Between changes, prices move the weights on their own, so the fund trades very little.
4. The expense ratio comes out of the fund a little each day. A fund charging 0.05% a year on a $10,000 holding takes $5 over the year, and the return you see is already net of it.
5. You own shares of the fund. A mutual fund share is priced once a day, at the close, at the fund's assets divided by its shares; an ETF share trades on an exchange through the day. Dividends the companies pay pass through to you.

Fund return = index return − expense ratio

An example

Two funds hold the same market, which returns 7% a year before fees, the example's assumption. One is an index fund charging 0.05% a year; the other is a managed fund charging 0.75% that, in this example, matches the market before its fee. Both start with $10,000 and add $300 a month.

Both investors put in $118,000. The gap at thirty years is $61,296, about 14% of the index fund's balance, and all of it is the extra 0.70% a year of fee, compounded, because the two funds held the same investments. For the managed fund to come out ahead, its manager would have to beat the market by more than 0.70% a year, on average, for thirty years.

Why it matters

The fund chosen inside a 401(k) or a brokerage account is one of the few investment decisions that is settled once and then compounds for decades, and the fee is the only part of it that is certain in advance. An index fund fixes the fee low and removes two risks at once: the risk that a manager picks badly, and the risk that one company fails, since one fund holds hundreds. What it does not remove is the market itself. An index fund falls exactly as far as its index in a bad year, and knowing that in advance keeps a household from selling the fund in the year it does what it was built to do.

Index fund versus an actively managed fund

An actively managed fund pays a manager to choose investments in the hope of beating an index; an index fund holds the index and accepts its return. The managed fund's fee is commonly ten or more times the index fund's, and it is charged whether the manager beats the index or not; the rate of return the investor keeps is the fund's return after that fee. An ETF, an exchange-traded fund, is a wrapper rather than a strategy: many index funds are ETFs, which trade on an exchange through the day like a stock, many are mutual funds priced once a day, and the index inside is the same either way.

Common questions

Is an index fund the same as an ETF? No. ETF describes how a fund is bought and sold, on an exchange during the day; index describes what a fund holds. Many index funds are ETFs and many ETFs track an index, but there are index mutual funds and actively managed ETFs.

Is an index fund the same as the S&P 500? No. The S&P 500 is the index, a list of companies and a number that reports how they did. An S&P 500 index fund is the investment that holds that list, and it is what you can actually buy; nobody can buy an index directly.

Can an index fund lose money? Yes, and it loses exactly what its index loses. It removes the risk of one company or one manager doing badly, not the risk of the whole market falling, and a broad index has fallen sharply in a bad year and recovered over the years that followed.

What is a good expense ratio for an index fund? The lowest available for the index you want. Broad index funds commonly charge a few hundredths of a percent a year, and the difference between two funds tracking the same index is almost entirely their fees.

Which index should I choose? For money with a decade or more to grow, a broad stock index, the whole US market or the S&P 500, is the usual core, with a bond index for the part that must not fall far; the split follows how soon the money is needed. The index decides what you own, so read the list before the fee.

Go deeper

• The Compound interest calculator shows how a starting balance and a monthly contribution grow at a given return over the years, and how much of the final amount is interest on interest rather than money you put in.
• The Retirement calculator projects what your retirement savings could grow to by the age you plan to stop working, what that is worth in today's dollars, and the monthly income it could support.
• How to track net worth when your investments swing every day reads the total once a month and splits each month's change into what you contributed and what the market moved.