What is an Index Fund and How Does it Work?

Index funds provide investors with a low-cost way to invest their funds across a diverse subset of stocks and bonds. Used correctly, they can be a reliable part of a healthy overall investment strategy.

Key Takeaways

Index funds are portfolios of investments focused on a specific market or sector of a market rather than individual companies.
There are many different types of index funds focused on everything from company size to where the market is located to how the targeted businesses conduct their operations.
Generally speaking, index funds are relatively low-cost ways to passively grow your wealth.
While index funds are usually a way for investors to increase their wealth, those seeking faster growth or larger gains might want to supplement their investments with some actively managed funds or stock portfolios.

What is an Index Fund?

An index fund is an investment tool designed to provide consistent growth by diversifying an investor’s assets.

Index funds are set up to provide a reasonable cross-section of a given market index in hopes that the fund’s growth will mimic the index on which it is based. Market indices, like the Dow Jones Industrial Average or the Nasdaq Composite, will fluctuate over time and as they do, index funds composed of stocks and bonds monitored by the chosen index will mirror those changes.

Common Types of Index Funds

There are a wide variety of index funds available tailored to investors’ goals and preferences. These might be organized by the types of businesses referenced by the fund, their size, or any number of other criteria that fund managers use.x

Broad Market – Broad market index funds cast the widest net, with the goal of the fund being to mirror all of the stocks and bonds in the chosen index as closely as possible.

Sector – Rather than mirroring an index like the S&P 500, sector index funds focus on a specific type of business. A healthcare index fund, for instance, would focus on investing in a diverse subset of companies in the medical field.

Domestic – Domestic index funds are focused on stocks and bonds related to a single country. In the United States, commonly monitored indices include the S&P 500 and the Nasdaq Composite.

International – International index funds provide a relatively low-risk and low-cost entry point to investing in global markets. Because index funds look at a broad swath of a market, it’s less necessary to have extremely specific knowledge of another country’s business environment before investing.

Bond – Not all index funds are focused on businesses and stocks. Bond index funds allow individuals to invest in the overall bond market in a given country using an index setup similar to those tracking corporate entities. One of the most popular is the Barclays Aggregate U.S. Bond Index.

Dividend – Dividend indices track companies that pay dividends to their investors. Rather than investing in the companies individually, investors can choose to put their money into an index fund that tracks those companies and pays out a proportional share of the dividends to its investors.

Index Fund Benefits

Index funds provide a large number of benefits to investors, including increased simplicity and lower costs. They are often lauded as simple, passive forms of wealth generation for those who invest in them.

Reduced Costs

Because index funds are set up to passively adhere to the fluctuations in a given market or sector of a market, they require less maintenance. There are fewer decisions to be made over time, and so they need fewer people managing them, bringing overhead down.

Reduced Risk

Index funds rely on diversification to provide diversified, consistent growth over time. While investing in individual companies can yield high returns, you are also at the mercy of any drastic changes at the business or in how the market views a particular entity. With a diversified set of investments provided by an index fund, investors are largely insulated from these risks.

Reduced Taxes

When investors buy and sell stocks and bonds, they’re required to pay capital gains tax on the proceeds of the sale. With a static set of investments based on a market index, there are fewer sales taking place and consequently fewer capital gains taxes being assessed. This type of stability gives index funds what’s known as “low turnover.”

Reduced Human Error/Bias

When an investor gets a hot tip, or even just a hunch, it can go several different ways. While it may be possible to predict certain market events, it’s just as likely that the prediction will sour and the investor will lose out. Index funds take this human element out of your investment strategy by spreading your money across so many individual investment vehicles.

Drawbacks of Index Funds

While index funds can provide great results for many investors, they’re not always the perfect solution for everyone. And, as with any type of investment, it’s important to diversify your choices as much as possible.

Lack of Flexibility

Index funds might not be the best option for investors who love the thrill of the chase, as their structure prevents people from tracking them from jumping on high-risk, high-reward opportunities. While they tend to show steady growth over time, your money is tied to these indices, regardless of what happens in the given market or sector they track.

Tracking Errors

Index funds are set up to mirror a market as closely as possible, but there will always be slight inconsistencies between the performance of a fund and the actual market it reflects. These errors can lead to short-term losses or missed opportunities for investors at times.

Large Company Bias

Many market indices are focused on large, well-established companies rather than smaller organizations with significant room to grow. This means investing solely in index funds could leave investors out of great opportunities relating to new, quickly growing businesses.

Lack of Downside Protection

Index funds generally perform well over time, but all markets can experience short-term volatility. When a market or industry takes a major hit, that will be reflected in your index fund investments.

How to Invest in an Index Fund

Investing in an index fund is similar to buying individual stocks through a brokerage account. Most major platforms—such as Vanguard, Fidelity, or Schwab—offer a wide range of index funds that track benchmarks like the S&P 500 or total market indexes.

General Process

Open a Brokerage Account – Choose a platform that offers index funds and set up your account.
Fund Your Account – Transfer money into your brokerage to start investing.
Pick an Index Fund – Search by name or ticker symbol. Check the fund’s performance and expense ratio.
Make a Purchase – Place a buy order just like you would with a stock.
Automate if You Want – Set up recurring investments or use a robo-advisor to manage it for you.

To determine the best course of action for your financial goals, consult a financial professional. Horizons Wealth Management provides a full range of financial planning services to help you make informed, confident investment decisions.

Bottom Line

Index funds provide a low-cost, diversified way to invest passively and grow wealth steadily over time. While generally safer and simpler than picking individual stocks, they may lack flexibility and expose you to broad market risks. For a tailored investment strategy, consider combining index funds with other options and consult financial experts like Horizons Wealth Management for personalized financial guidance.

Index Fund FAQ

Are index funds a good investment?

Just like any investment strategy, it depends largely on what the investor’s goals and preferences are. Index funds are a good fit for anyone seeking a low-cost entry into investing in a certain market or industry.

Is the S&P 500 an index fund?

The S&P 500 is a market index that specifically tracks 500 or so of the largest publicly traded companies in the United States. This market index is the basis for certain index funds.