Index Fund

An index fund is a mutual fund, ETF or unit investment trust that follows a passive strategy designed to achieve approximately the same return as a particular market index, before fees.

How an index fund works

The SEC's Investor.gov glossary defines an index fund as a mutual fund, ETF or unit investment trust that follows a passive investment strategy designed to achieve approximately the same return as a particular index before fees. The fund attempts to meet that objective primarily by investing in the securities of the companies included in the selected index; some hold a representative sample or use derivatives such as futures to help track it. Investor.gov notes that passive management usually translates into less trading and therefore lower transaction costs, more favorable income-tax consequences through lower realized capital gains, and lower fees and expenses than actively managed funds. The index itself is maintained by a provider that sets the rules for which securities are included and how they are weighted, most often by market capitalization.

Hypothetical example: an index returns 8.0% in a year. A fund tracking it with a 0.10% expense ratio returns about 7.9%; one charging 0.60% returns about 7.4%. See ETF.

Why costs dominate index fund selection

Because funds tracking the same index hold essentially the same securities, the main differences between them are expense ratio, tracking error and, for ETFs, trading costs. Investor.gov states that over time higher fees and expenses can significantly lower investment returns, and the effect compounds: a fee is deducted every year from a growing balance. Index funds also carry the full risk of the index they follow; a fund tracking a stock index will fall as much as that index in a bear market, and a narrow sector or country index concentrates risk. The SEC's asset allocation guidance points out that a total stock market index fund can own stock in thousands of companies, which provides broad diversification within the equity portion of a portfolio, while a fund focused on one industry does not necessarily provide diversification.

Hypothetical example: $10,000 invested for 30 years at 7% before fees grows to about $74,000 at a 0.10% expense ratio but only about $63,000 at 0.60%. Test your inputs in the fee drag calculator.