What is an Index Fund?

Looking for a simple investment that Warren Buffett and Charles Schwab both recommend? Try an index fund. An index fund is a specific type of mutual fund that mirrors the performance of a market index. An index fund spreads your investment across many different companies, which makes it diversified.

What is the definition of an index fund?

An index fund is a specific type of mutual fund with a defined mix of assets. An index fund mimics the performance of a major market index. It’s a diversified investment that, over time, should give you similar returns to what you’ll see in the market index it follows. To understand more about what an index fund is, it’s important to know what the underlying terms mean.

What is a mutual fund?

A mutual fund combines money from multiple investors to purchase stocks, bonds, and other types of investments. The benefit of a mutual fund is that it’s professionally managed. It’s also diversified because the fund holds different types of investments. Some mutual funds have low minimum investments, reducing barriers to entry. Mutual fund value is determined by the fund’s  Net Asset Value (NAV). The NAV of a mutual fund is the sum of the fund’s assets, minus its liabilities, divided by the number of shares. 

What is a market index?

A market index tracks the prices of a group of assets. There are many different market indices. The Dow Jones Industrial Average tracks stock prices of 30 American companies representing different sectors. 

The S&P 500 contains the stocks of 500 large US-based companies. It’s considered to be a reliable gauge of the health of the market.

There are also market indices for bonds. Barclays Capital US Aggregate Bond Index is a popular bond index. It tracks the performance of US treasury securities, mortgage-backed securities, government bonds and corporate bonds. 

There are other specialized market indices. Every market index tracks the performance of investments in various sectors. 

How does an index fund work?

An index fund should perform like one of the major market indices. For example, the value of an S&P 500 index fund will track very closely with the value of the S&P 500 market index as a whole. So, when the S&P 500 goes up, the S&P 500 index fund should, in theory, go up too even though the fund itself doesn’t contain all 500 companies on that index.

The benefit of an index fund, as previously mentioned, is that it’s a diversified investment. With an index fund, you can invest in a collection of stocks or bonds instead of in a few investment instruments. The asset value of an index fund will tend to be more stable than the values of individual stocks. The variability of different stocks within the index fund should balance each other out. 

Index funds also have low minimum investment options so you can get started right away. And, they’re liquid assets, which means that you can withdraw your money at any time without a penalty.

What is the difference between an index fund and a mutual fund?

Even though an index fund is a type of mutual fund, there are some differences between the two. For example, some mutual funds are actively managed – meaning that fund managers are hands-on with the investments, trying to beat the market. 

Index funds are passively managed, meaning they contain a certain ratio of stocks. Algorithms can automatically manage an index fund without human intervention. Because index funds are passively managed, they typically have lower fees than actively managed mutual funds.

Additionally, index funds track a particular market index, like the S&P 500 or Dow Jones Industrial Average.

How to invest in an index fund

You can buy an index fund via a brokerage or retirement account. If you have an employer-sponsored 401(k), review the options to see if you can invest in an index fund. For those who don’t have a 401(k), consider opening a Traditional IRA or Roth IRA.

Most brokerages also allow you to invest in an index fund. You can purchase shares in a low-cost index fund via an online or full-service broker. 

The biggest decision is deciding which market index you want to invest in. The S&P 500 tracks the overall performance of large companies, while the Dow Jones Industrial Average focuses on a smaller subset of big corporations. Stock index funds will have a greater risk than bond funds, but the potential return is also higher on stock-based index funds. There are also total market indexes and international indexes. Consult a fee-only financial advisor that you trust if you need help choosing which fund is best for you.

Index Fund FAQs

Here are some of the most commonly asked questions about index funds.

How much does it cost to invest in an index fund?

Many index funds have low fees because they’re passively managed. Some of the major brokerage firms offer index funds with fees between 0.015 percent and 0.04 percent. In addition to index fund fees, you’ll sometimes pay a fee to buy or sell shares of an index fund. Check with your broker or investment manager to see what their fee structure is. Sometimes certain low cost brokerages will not charge buy fees if you buy their branded index funds.

How do I choose an index fund?

You should decide how much risk you want to take when choosing an index fund. Stock index funds will be higher risk, while bond index funds will be lower risk. On the flip side, historical returns on stock market indices are higher than those on bond indices. You should choose an index fund based on your personal risk comfort level. You can research the historical performance of index funds or speak to a trusted fee-only financial advisor who can help you.

Also, consider the fees for index funds, and compare them on the different index funds you are considering. Finally, check the minimum investment for an index fund. Decide how much you’re able to invest and choose a fund with an appropriate account minimum.

Why Should You Consider Investing in an Index Fund?

Investing in an index fund is a simple way to diversify your portfolio without much cost or effort on your part. Since index fund fees and minimum investments are often low, they’re accessible to beginning investors. You can withdraw your money at any time and choose from a range of different indices based on your preferred risk level. With so many investment instruments available, index funds are a great place to start because they’re straightforward, easy to understand, and a simple way to diversify your investments quickly and easily.