Index Fund

A market index measures a basket of securities chosen to represent part of a market, such as the roughly 500 large US companies in the S&P 500 or the whole US investment-grade bond market. You cannot buy an index directly, but you can buy a fund that copies it. Some index funds hold every security in the index at its index weight, called full replication; others hold a representative sample, which is cheaper for very broad or hard-to-trade markets but can track the index less closely.

The fund’s weights follow the index. Many indexes weight each company by market capitalization, its share price times shares outstanding, so the largest companies get the most money. A few, like the Dow Jones Industrial Average, are price-weighted instead. When the index adds or drops a company, the fund trades to match; otherwise it mostly sits still. That low turnover, with no research team to pay, is why index funds are usually cheap.

An actively managed fund pays analysts and portfolio managers to pick securities in the hope of beating a benchmark. An index fund gives up that chance and settles for the benchmark’s return minus its costs. That trade favors the index fund more often than it sounds. As the SEC puts it, a fund with higher costs must perform better than a lower-cost fund just to generate the same return, so an active manager has to beat the index by more than the extra cost, year after year, before its shareholders come out ahead. S&P Dow Jones Indices publishes a regular SPIVA scorecard that tallies how many active funds trail their benchmarks, counting funds that closed or merged along the way.

Costs explain much of the gap. The Department of Labor notes that passively managed funds generally carry lower management fees, and that neither active management nor higher fees guarantee higher returns. Index funds are not automatically cheap, though. The SEC warns that some cost more than actively managed funds, so check the expense ratio of any fund before you buy it.

Start with the account, then the fund. Inside a 401(k) you choose from the plan’s menu, so look for its broad index options. In an IRA or a taxable brokerage account, almost any index fund is available.

Next choose the wrapper, since the same index is often sold both ways. You buy an index mutual fund from the fund itself or through a broker, at the net asset value calculated at the end of each business day. An index ETF trades on an exchange throughout the day at market prices that can sit slightly above or below its net asset value. In a taxable account, ETFs typically distribute fewer capital gains; inside a 401(k) or IRA, the SEC notes, the structure makes no tax difference. Then check a few details:

Index funds are as broad or as narrow as the index they follow. Broad funds make natural core holdings, and a simple mix of three of them is the whole of the three-fund portfolio. Narrow funds are concentrated bets that happen to be packaged cheaply: a low-cost fund tracking one industry is still a wager on that industry. Read which index the prospectus names and how that index picks and weights its members, rather than relying on the fund’s name. The main families:

An index fund carries the full risk of whatever it tracks. It will not move to cash before a downturn, so a stock index fund falls with its market in every bear market. It will also trail its index slightly, a gap called tracking difference, because of fees, trading costs and, in sampled funds, holdings that do not exactly match the index. None of that makes an index fund unsuitable for a long horizon, but low cost is not the same as low risk.

Most mistakes come from choosing and using the funds, not from indexing itself: