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What Is an Index Fund & How Does One Work?

Person researching index funds at home

One of the potential benefits of mutual funds is the diversification that comes with owning a mixed portfolio of stocks or bonds. By hand-picking the individual securities within that basket, fund managers try to generate above-average returns for their investors.

Index funds have a similar objective and also try to create gains, but they don't try to beat the market. None of the strategies mentioned, however, can guarantee asset growth, and investments may still lose value.

Here's more information on the definition of an index fund, as well as some of the potential benefits and drawbacks.

What Is an Index Fund?

An index fund is a mutual fund or exchange-traded fund (ETF) that tracks an index. It may track the Russell 2000 or S&P 500, which measure the performance of the largest publicly traded companies in the U.S., but other funds track bond indices like the Barclays Aggregate Index, which consists of thousands of individual bond issues.

Some index funds are equal-weighted, meaning that the fund owns the same amount of every company within the index. Others use market-weighting, where larger companies represent a bigger percentage of its holdings. Index funds are popular vehicles for individual retirement accounts (IRAs) and 401(k)s.

Potential Benefits of Index Funds

There are a number of reasons why indexing has gained traction in recent years. First, it can result in a lower annual expense ratio due to the fact that the fund doesn't need to hire a team of experts to research and select individual stocks and bonds that go into the fund.

Passive investments also tend to create lower tax bills for the people who use them. Index funds buy and sell securities less often than active rivals. Making fewer trades can lead to fewer taxable events that get passed on to the fund owners.

Because index funds own hundreds — or even thousands — of individual securities, they can also help insulate investors from individual companies that perform poorly. This also does not guarantee growth or protection from loss of value, however.

Potential Drawbacks of Index Funds

Before investing in index funds, it's important to understand their limitations. For example, despite their large number of holdings, passive funds often focus on only one part of the market. A fund pegged to the S&P 500 will give you exposure to large cap U.S. stocks, but not to small-cap companies or international corporations.

There are also some markets where you might prefer to have an active fund manager at the helm. One example: funds that invest in emerging economies with histories of political and economic instability. An expert stock picker may be able to help steer the fund out of adverse events and help minimize the potential loss. That is also not a guarantee, however, and any stock investment can undergo unpredictable loss.

In addition, some of the more popular bond index funds are weighted based on the size of the bond issue. That means they may skew heavily toward U.S. government debt. That may or may not be a good thing, depending on your investment objectives. While treasury bonds offer a higher level of safety than most forms of debt, they also typically yield lower potential returns than corporate bonds.

Are Index Funds Right for You?

Knowing the definition of an index fund and understanding how they work can help you decide what's best for you. You might want to consider what's actually in an index mutual fund or ETF before choosing to make a purchase, and you'll also likely want to determine whether you're comfortable having your holdings determined by an index. Consider speaking with a financial representative to determine the best approach for your financial road map.

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