The basic concept
An index fund is an investment fund designed to track the performance of a specific market index. Rather than employing analysts to pick stocks they believe will outperform, index funds simply own all (or a representative sample) of the securities in their target index.
The S&P 500 index tracks 500 large U.S. companies. An S&P 500 index fund owns shares of those same 500 companies in proportions matching the index. When the index rises 10%, the fund rises approximately 10%. When it falls 15%, the fund falls approximately 15%.
This passive approach contrasts with active management, where fund managers research companies, predict which will outperform, and construct portfolios based on those predictions. Active funds attempt to beat the market; index funds attempt to match it.
Why matching the market works
At first glance, aiming to match the market seems unambitious. Why not try to beat it? The answer lies in the aggregate math of markets and the impact of costs.
All investors collectively own the entire market. For every investor who beats the market, another investor must underperform by the same amount; the outperformance has to come from somewhere. Before costs, the average investor earns exactly the market return.
After costs, the average investor earns the market return minus costs. Active management costs more: research analysts, trading expenses, higher management fees. Index funds cost less: no research staff, minimal trading, lower fees.
If active and passive investors both start with market returns, but active investors pay 1% more in annual fees, active investors as a group underperform index investors by roughly 1% annually. This isn’t theory; decades of data confirm it.
Studies consistently show that over 15-20 year periods, 80-90% of actively managed funds underperform their benchmark indexes after accounting for fees. The active managers who outperform vary period to period, and past outperformance doesn’t reliably predict future outperformance.
The cost advantage
Index fund costs are dramatically lower than active fund costs because passive management requires dramatically less infrastructure.
Typical actively managed mutual fund: 0.50% - 1.50% annual expense ratio Typical index fund: 0.03% - 0.20% annual expense ratio
This difference, seemingly small, compounds over decades. Consider $100,000 invested for 30 years at 7% gross return:
- At 0.05% expense ratio: grows to $736,000
- At 1.00% expense ratio: grows to $574,000
The higher-cost fund delivers $162,000 less, roughly 22% less final wealth, from the same starting amount and same gross returns. The fee drag compounds year after year.
Beyond expense ratios, active funds incur higher trading costs (buying and selling stocks frequently costs money) and create more taxable events (realized gains trigger taxes in taxable accounts). These hidden costs further advantage index funds.
Types of index funds
Broad market index funds track entire asset classes. The total U.S. stock market index includes approximately 4,000 companies across all sizes and sectors. The total international stock market index covers developed and emerging market companies worldwide. The total bond market index includes thousands of government and corporate bonds.
Segment-specific index funds target portions of markets. S&P 500 funds track large U.S. companies specifically. Small-cap index funds track smaller companies. Sector funds track industries like technology or healthcare. International developed market funds exclude emerging markets. These allow tilting portfolios toward specific exposures.
Bond index funds track fixed-income markets. The Bloomberg U.S. Aggregate Bond Index is the most common benchmark, including Treasury bonds, corporate bonds, and mortgage-backed securities. Treasury-only, corporate-only, and municipal bond index funds provide more targeted bond exposure.
Target-date index funds combine multiple index funds into a single package that automatically adjusts allocation over time. A 2055 target-date fund holds mostly stock index funds now and gradually shifts toward bond index funds as 2055 approaches. These provide hands-off portfolio management for retirement savers.
Mutual funds vs. ETFs
Index funds come in two structures: mutual funds and exchange-traded funds (ETFs). The underlying investments can be identical; the structure affects trading, minimum investments, and minor tax considerations.
Mutual funds trade once daily at the closing net asset value (NAV). Purchases and sales execute at the same price for everyone transacting that day. Minimum investments are common ($1,000-$3,000 for many funds, though some brokerages allow fractional shares). Dividends can automatically reinvest without commission.
ETFs trade throughout the day on exchanges like stocks. Prices fluctuate based on supply and demand, though arbitrage keeps prices close to NAV. No minimum investment beyond the price of one share (or fractional shares where offered). Slightly more tax-efficient due to “in-kind” redemption mechanisms that avoid capital gains distributions.
For most investors, the differences are minor. ETFs work better for small, frequent investments since there’s no minimum. Mutual funds work better for automatic recurring investments in some brokerage systems. Both provide the same underlying index exposure.
Building a portfolio with index funds
The simplest portfolio using index funds is a “three-fund portfolio”: one total U.S. stock market fund, one total international stock market fund, and one total bond market fund. These three funds provide exposure to essentially all global stocks and bonds.
Asset allocation, the split between stocks and bonds, determines portfolio risk level. Younger investors with decades until retirement typically hold more stocks (80-100%) for higher expected returns despite volatility. Investors approaching or in retirement typically hold more bonds (40-60%) for stability and income.
Geographic allocation determines domestic versus international exposure. U.S. stocks have outperformed international stocks for the past decade, but international stocks have outperformed in other periods. Holding both provides diversification across regions.
A typical allocation for a young investor might be:
- 60% Total U.S. Stock Market Index Fund
- 30% Total International Stock Market Index Fund
- 10% Total Bond Market Index Fund
For someone in retirement:
- 30% Total U.S. Stock Market Index Fund
- 15% Total International Stock Market Index Fund
- 55% Total Bond Market Index Fund
These are illustrative, not prescriptive. Appropriate allocation depends on risk tolerance, time horizon, other assets, and personal circumstances.
What indexes actually contain
S&P 500: 500 large U.S. companies selected by a committee at S&P Global. Represents roughly 80% of U.S. stock market capitalization. Heavily weighted toward largest companies; the top 10 holdings might represent 25-30% of the index. Dominated by technology, healthcare, and financial companies.
Total U.S. Stock Market (CRSP or Wilshire): Approximately 4,000 U.S. companies across all sizes. Includes the S&P 500 plus thousands of smaller companies. More diversified across company sizes than S&P 500 alone.
MSCI EAFE: Developed international markets, excluding U.S. and Canada. Includes Japan, UK, France, Germany, Australia, and other developed economies. Does not include emerging markets.
MSCI Emerging Markets: Developing economies including China, Taiwan, India, Brazil, South Korea (classified as emerging despite development level). Higher growth potential with higher volatility.
Bloomberg U.S. Aggregate Bond: Investment-grade U.S. bonds including Treasury, government agency, corporate, and mortgage-backed securities. Does not include municipal bonds, high-yield corporate bonds, or international bonds.
Index construction matters. Market-cap weighted indexes (most common) weight holdings by size, meaning larger companies represent larger portions of the fund. This can concentrate holdings in the largest stocks. Equal-weighted alternatives exist but with higher costs and different risk characteristics.
The case against index funds
Index funds aren’t perfect. Critiques include:
No protection from market declines. Index funds fall when markets fall. During the 2008 financial crisis, total stock market index funds lost approximately 50%. Passive investing means passively participating in crashes.
Concentration in largest companies. Market-cap weighting means huge allocations to the largest companies. When those companies are overvalued, index funds are overexposed to them.
Index inclusion creates buying pressure. When a company enters an index, all index funds must buy it, potentially at inflated prices. Index funds are price-insensitive buyers by design.
No opportunity for outperformance. Index funds guarantee market returns minus fees. Someone who successfully identifies outperforming active managers could earn higher returns. The challenge is that identifying them in advance is extremely difficult.
Crowding effects. With trillions of dollars in index funds, their trading activity can affect markets. Price discovery may deteriorate if fewer active managers are analyzing individual companies.
These critiques have merit but don’t change the fundamental cost-benefit analysis for most investors. The certain cost savings from low fees exceed the uncertain potential benefit of active management for the vast majority.
How to evaluate index funds
When comparing index funds tracking the same index:
Expense ratio is the most important factor. Lower is better, all else equal. The difference between 0.03% and 0.15% seems small but compounds over decades.
Tracking error measures how closely the fund follows its index. Lower tracking error indicates better replication. Most major index funds track extremely closely.
Fund size affects liquidity and operational efficiency. Very small funds may have higher costs or closure risk. Major index funds from Vanguard, Fidelity, and Schwab are all large and stable.
Tax efficiency matters in taxable accounts. ETFs are generally more tax-efficient than mutual funds due to structural differences in how redemptions are handled.
Investment minimums may restrict access to some funds. Many brokerages now offer $0 minimums and fractional shares, making this less relevant.
For broad market index funds from major providers, differences are minimal. Vanguard Total Stock Market Index Fund, Fidelity Total Market Index Fund, and Schwab Total Stock Market Index Fund are functionally interchangeable.
Implementation considerations
Dollar-cost averaging means investing fixed amounts at regular intervals regardless of price. This removes timing decisions and ensures consistent investment behavior through market fluctuations. Index funds are well-suited to this approach.
Rebalancing maintains target allocations as different assets grow at different rates. If stocks outperform bonds, the portfolio becomes stock-heavy and needs rebalancing back to target. This can be done annually or when allocations drift beyond thresholds (e.g., 5% from target).
Tax location matters when holding index funds across account types. Bond funds generate ordinary income, making them more tax-efficient in retirement accounts. International funds often have foreign tax credits that benefit taxable accounts. Stock index funds work well in any account type.
Avoiding behavioral errors matters more than fund selection. The investor who holds through volatility and continues contributing during downturns outperforms the investor who panic-sells or tries to time the market, regardless of which specific index fund they own.