What is an index fund and should I invest in one?

An index fund is a mutual fund or ETF that simply copies a market index. An S&P 500 index fund owns the roughly 500 companies in that index, in the same proportions. Nobody at the fund is trying to guess which stocks will do best; the fund just follows the list.

Why so many experts recommend them

• Low cost. No team of analysts to pay. Many broad index funds charge 0.03% to 0.10% a year, versus 0.5% to 1% or more for many actively managed funds. Over decades, that difference adds up to a large sum (see how fees eat returns).
• Instant diversification. One fund can hold hundreds or thousands of companies. Why diversification matters.
• Hard to beat. S&P Dow Jones Indices publishes a regular scorecard (SPIVA) showing that, over 15 years, the large majority of actively managed US stock funds have trailed their index.
• Tax efficiency. Low turnover usually means fewer taxable distributions in a regular brokerage account.
• Simplicity. Less to research, less to worry about.

Common indexes you will see

• S&P 500: large US companies.
• Total US stock market: large, mid-size and small US companies, several thousand in all.
• Total international: developed and emerging markets outside the US.
• US aggregate bond: a broad mix of investment-grade US bonds.

The limits

• An index fund will never beat its market. You get the market’s return, minus a small fee.
• It falls with the market. An S&P 500 fund lost about 37% in 2008.
• Some popular indexes are concentrated: in recent years a handful of large technology companies made up a big share of the S&P 500.
• Not every product called “index” is cheap or broad. Some track narrow or unusual indexes.

How to choose one

1. Decide which market you want: US total market or S&P 500 for a core holding, plus international and bonds as your allocation requires.
2. Compare expense ratios. For broad funds, look for very low costs.
3. Check the minimum. Some mutual funds require an initial investment; ETFs cost one share or less with fractional shares.
4. Mutual fund or ETF? Both work; see mutual funds vs index funds and how ETFs work.

Should you invest in one?

For most people building long-term wealth, a low-cost broad index fund is a sensible core. Many investors hold nothing else. The SEC’s Investor.gov definition of index funds is a neutral starting point.