Funds & ETFsExplainer
What is an index fund, and how does it track the market?
An index fund tries to match a market index instead of beating it. Learn how tracking, weighting, costs and tracking error work, with simple numbers.
Quick answer
An index fund is a mutual fund or ETF that tries to earn about the same return as a market index, such as the S&P 500, before fees. Instead of picking securities, it holds the index's securities or a sample, which usually means less trading and lower costs.
Key points
- An index fund aims to match an index's return before fees, not to beat it.
- In a market-cap-weighted index, bigger companies get bigger weights, so a few large stocks can move the whole fund.
- Passive management usually means less trading, lower fees and fewer realized capital gains than active management.
- An index fund still falls when its index falls, and fees and tracking error mean it can trail the index slightly.
What is an index fund?#
The SEC defines an index fund as a mutual fund or exchange-traded fund that seeks to track the returns of a market index[1]. Its glossary adds that the goal is approximately the same return as a particular index before fees[2]. It is a strategy, not a separate legal product: you can find index funds as mutual funds and as ETFs.
A market index measures the performance of a basket of securities meant to represent a market or a sector of the economy[3]. The S&P 500, the Russell 2000 and the Wilshire 5000 Total Market Index are examples that index funds may track[3]. You cannot invest in an index directly; an index fund is an indirect way to get its return[3]. For more on indexes themselves, see stock market indexes.
One widely tracked index, in its provider's words
How does an index fund copy its index?#
The SEC says index funds take different approaches: some invest in all of the securities in the index, while others invest in only a sample[3]. Some also use derivatives such as options or futures to help reach their objective[2]. A fund that holds only a sample may be less likely to match the index exactly[1].
The fund also has to copy the index's weighting — how much of each security it holds. In a market-cap-weighted index, companies with a higher market capitalization make up a bigger share of the index[3]. Some indexes, such as the Dow Jones Industrial Average, are price-weighted instead, so the share price sets the weight[3]. See market capitalization for how company size is measured.
Worked example
Worked example: a four-company cap-weighted index
Imagine a tiny index of four companies worth $600 billion, $250 billion, $100 billion and $50 billion. A fund that copies it puts $1,000 in the same proportions. If Company A falls 10% and the others stay flat, the $1,000 becomes $940.00, a 6.0% drop. If Company D rises 10% instead, it becomes $1,005.00, a 0.5% gain. Company names and values are invented for illustration.
| Company | Market value | Index weight | Of $1,000 |
|---|---|---|---|
| Company A | $600B | 60% | $600.00 |
| Company B | $250B | 25% | $250.00 |
| Company C | $100B | 10% | $100.00 |
| Company D | $50B | 5% | $50.00 |
Figures computed in code from the stated inputs; rounded to the nearest cent or tenth.
Weights in the four-company example
Why do index funds usually cost less?#
Index funds have generally followed a passive style: they aim for long-run returns by not buying and selling very often[1]. Because the managers are not picking securities, they do not need research analysts to help pick them[1]. The SEC's glossary sums up the effect: passive management usually means less trading, more favorable tax results through lower realized capital gains, and lower fees and expenses than actively managed funds[2].
| Feature | Index fund | Actively managed fund |
|---|---|---|
| Goal | Match an index's return before fees | Choose securities aiming to do better |
| Who picks holdings | The index rules | The adviser and its analysts |
| Trading | Usually less | Usually more |
| Fees and expenses | Usually lower | Usually higher |
| Can react to a falling market | Less flexibility | Manager can change holdings |
Based on the SEC's index fund glossary entry and investor bulletin[2][1]. Individual funds vary; check each prospectus.
Costs matter because they come straight out of the return you get. Over time, higher fees and expenses can significantly lower investment returns[2]. Our note on expense ratios shows the arithmetic over 10 and 30 years.
Why doesn't an index fund match its index exactly?#
An index has no costs; a fund does. The SEC lists three reasons an index fund may underperform its index: fees and expenses, trading costs, and tracking error[3]. Tracking error means the fund does not track its index perfectly; for example, a fund that invests in only a sample of the index's securities may be less likely to match the index[1].
What are the risks of index funds?#
An index fund carries the same general risks as the securities in the index it tracks[3]. If the index drops 20%, a fund that tracks it closely drops about 20% too. The SEC also flags a lack of flexibility: an index fund may have less room than a non-index fund to react to price declines in the securities in the index[1].
Not every fund with "index" in its description is a plain market tracker. So-called smart beta or quant funds use custom-built indexes to choose their investments, typically have higher expenses than traditional index funds, and may behave very differently than the market[5]. Read how the index is built before assuming it is broad; see diversification for why breadth matters.
Ask what it costs
What fees and expenses will you pay for buying, owning and selling the fund?[1]
Ask what can go wrong
What specific risks come with this fund and its index?[1]
Ask how the index is built
How is the makeup of the fund's index determined — by size, by price or by custom rules?[1]
Ask whether it fits your goal
How does the fund's strategy fit with your investment goals and time horizon?[1]
What mistakes do beginners make?#
Thinking "index fund" means low risk
An index fund removes the risk of a manager's bad picks, not the risk of the market. A stock index fund can fall sharply in a bear market.
Assuming all index funds are the same
Funds tracking different indexes — large companies, small companies, bonds, one sector, a custom smart-beta index — behave very differently. Compare the index, not just the word "index".
Ignoring concentration
In a cap-weighted index a handful of large companies can carry a large share of the weight, as the four-company example shows. Look at the fund's top holdings.
What else do beginners ask?#
Is an index fund a mutual fund or an ETF?
It can be either. The SEC's glossary says an index fund can be a mutual fund, an ETF or a unit investment trust[2].
Can I buy the S&P 500 directly?
No. You cannot invest directly in a market index; index funds that track it offer an indirect way to get its return[3].
Why does my index fund trail the index a little?
Because of fees and expenses, trading costs and tracking error, which the index itself does not have[3].
Do index funds pay fewer taxable distributions?
Often, yes. Passive management usually means fewer realized capital gains than active management[2], though it depends on the fund, and rules differ by country.
What is the bottom line?#
An index fund trades the chance to beat the market for a close copy of it, usually at a lower cost. How closely it copies depends on its method and its fees, and what you own depends entirely on the index — its weighting, its breadth and its risks. Read how the index is built and what the fund charges before comparing anything else.
Sources
Numbers in brackets in the text point here. Grade A = primary source (regulator, statistics agency, law or official document).
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