What Are Index Funds?

Index fund definition

“Index funds are similar to mutual funds in that they represent a collection of investments within the confines of a single vehicle (the fund),” explained Frank Murillo, a certified financial planner and managing director at Snowden Lane Partners.

“What separates index funds from other funds is their passive investment style. All things being equal, they’re intended to clone the index they represent — no more and no less. For example, an S&P 500 index fund will mimic the returns of the S&P 500 without deviation. A benefit of index funds is that they tend to be lower in cost and taxation.”

Index funds hold all of the securities represented within an index, and are typically weighted according to the market capitalization of that security.

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How do index funds work?

Index funds allow investors to invest in a basket of securities within a single fund, giving them broad diversification with low expense ratios. Index funds are also more tax-efficient than actively managed funds, as they rebalance less frequently and don’t actively trade securities within the fund.

The goal of an index fund is to hold the securities that are represented within a specific index and balance the fund based on the market cap of each asset. That means that assets with a larger market cap represent a larger holding than those with a smaller market cap.

For example, the S&P 500 index fund is market-cap weighted, meaning the top 10 holdings include the largest companies in the U.S., including Apple, Microsoft, Amazon, NVIDIA and Alphabet (Google).

What is a market index?

A market index is an industry benchmark created to follow the performance of a market segment or asset class. Broad-based indices track the performance of an overall market, such as the MSCI U.S. Equity Index, which tracks the entire U.S. stock market.

More narrow indices track smaller market segments, such as the Nasdaq-100 index, which tracks 100 of the largest nonfinancial companies listed on the Nasdaq stock exchange.

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Index fund returns

Index funds provide returns in multiple ways, including:

• Market value increases: Index funds go up in value as the index they track increases in value. The value increase is due to the underlying holdings of the index fund.
• Dividend payments: Many assets pay regular dividends, and these are passed to index funds holders, as they own small portions of many dividend-paying assets.

Index fund performance mirrors that of the index they are tracking. There are some very slight deviations from the index, but for all intents and purposes, the returns are identical.

Broad-based stock market index funds (such as the S&P 500) have averaged around 10% returns annually since 1957. U.S. Treasury bonds have averaged around 5.85% per year since 1957. And U.S. corporate bond funds have averaged around 7.72% per year since 1957.

How are index funds taxed?

Index funds are taxed like any other mutual fund. Capital gains are assessed when you sell an index fund, and dividend payments count as ordinary income.

When selling an index fund, your capital gains tax rate depends on how long you’ve held the fund and your income. Here are the capital gains tax rates for selling index funds in 2023 based on your taxable income:

If you sell your index fund for a loss, you can deduct the loss from your capital gains for the year or carry it over to deduct in the future.

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Types of index funds

There are several types of index funds that track different indices, including:

• Broad market index funds follow a larger market index, such as the Dow Jones Industrial index or MSCI U.S. Equity index. These own the entire market and are typically market-cap weighted.
• Sector-based index funds own all of the assets within a specific market sector, such as technology, energy, health care or finance.
• Equal weight index funds own an equal amount of each stock within the index. Instead of basing the invested amount on market cap, it’s split evenly with all the other assets within the index.
• Price weight index funds weigh the amount invested in each asset by its market price. This means assets with higher prices have a larger holding within the index fund.
• Factor-based index funds (also known as Smart Beta index funds) are weighted based on multiple factors, such as price-to-earnings (P/E) ratio, cash flow, book value and dividend yield.

How to invest in index funds

To purchase index funds, you’ll need to open a brokerage or retirement account with an investment firm or other financial institution that offers access to index funds.

Here are the steps to take to invest in index funds:

• Choose a broker or financial firm you trust
• Pick an account type (brokerage, IRA, other)
• Search for index funds to invest in
• Choose your investments and deposit funds to invest

Note that many index funds have a minimum investment requirement. For example, VTSAX, Vanguard’s Total Stock Market Index Fund, requires a $3,000 minimum investment.

If you have less money to invest, most index funds have an exchange-traded fund (ETF) equivalent that lets you invest for the price of one share. For example, the same fund (VTSAX) is available as an ETF (ticker symbol VTI) and you can purchase it for the price of one share — around $220 per share as of publishing.

And if you want to invest even smaller amounts, some brokers and investing apps let you invest in fractional shares, allowing you to invest as little as $1 at a time.

Index fund examples

There are hundreds of index funds to choose from dozens of financial institutions. Here are a few of the most popular ones available today:

• Vanguard S&P 500 Index Fund (VFIAX) tracks the S&P 500 index. It is a market-cap weighted index fund.
• Schwab US Aggregate Bond Index Fund (SWAGX) owns over 8,000 government and investment-grade bonds with a very low expense ratio.
• Fidelity MSCI Energy Index ETF (FENY) tracks the MSCI Energy Index, which tracks large- and mid-cap segments across 23 Developed Markets globally.
• SPDR Dow Jones Industrial Average ETF Trust (DIA) tracks the Dow Jones Industrial Average, which is a price-weighted index following 30 large U.S. companies.

Index funds vs. mutual funds

Index funds are mutual funds, but not all mutual funds are index funds.

A mutual fund is a collection of securities, such as stocks, that are put together by a financial firm so investors can own multiple securities within a single investment.

There are various types of mutual funds that can be customized by fund managers. These funds may or may not track an industry benchmark, such as a market index, but many times they are curated by fund managers to meet a specific risk profile or other financial goal.

An index fund is a type of mutual fund that tracks a specific market index. They are typically passively managed, meaning they don’t actively trade securities or rebalance frequently, but rather try to mirror an industry benchmark, such as the S&P 500.

Index funds vs. ETFs

Index funds and ETFs both offer a way to hold hundreds (or even thousands) of investments within a single fund. Both are typically very low-cost, and both are primarily passively managed.

ETFs allow investors to buy portfolios of stocks, bonds or other assets inside a single fund. That fund is tradable on a market exchange, such as the New York Stock Exchange.

Index funds also hold portfolio securities inside a single fund, but they aren’t as tradable as ETFs. You can purchase index funds by placing an order, and it will close at the end of the trading day.

Here are a few other differences between index funds and ETFs:

FAQ

Bottom line

Investing in index funds is a core part of most long-term investor strategies. With low fees, a long track record of stable performance and broad diversification, index funds are one of the better investment options available today.

But as with any investment, it’s important to research any index fund before choosing to invest. A licensed financial advisor can also help you construct a financial plan to fit your needs and goals.