What Is an Index Fund and How Do They Work?

An index fund is an investment fund that aims to match the performance of a specific market index, such as the S&P 500 or the Nasdaq Composite. Instead of trying to pick individual winners, the fund holds the same basket of securities as its chosen index and adjusts its holdings only when the index changes. This structure keeps costs relatively low and gives investors broad market exposure through a single investment. Index funds can be purchased through mutual funds or exchange-traded funds (ETFs), depending on how an investor prefers to trade and manage their portfolio.

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How an Index Fund Works

An index fund follows a specific market index by holding the same mix of securities that make up that benchmark. Instead of relying on a manager to decide which stocks or bonds to pick, the fund’s holdings shift only when the underlying index changes. The objective is to mirror market performance rather than outperform it, which is why index funds are considered passively managed.

The first modern index fund was introduced by John C. “Jack” Bogle, founder of Vanguard, who promoted low-cost investing and broad market diversification. Many index funds still follow this model by keeping fees relatively low compared to actively managed alternatives.

Index funds can be structured as mutual funds or ETFs, and both formats rely on passive management to track their chosen benchmarks. Mutual funds process trades once per day after the market closes, while ETFs trade throughout the day like stocks. The choice between them typically comes down to trading preferences, cost differences and how an investor wants to build their portfolio.

Reasons to Invest in Index Funds

So why are index funds popular if they don’t purport to beat the market? Well, index funds have a few things going for them that make them attractive to investors. For one thing, they charge lower fees than actively managed funds.

Low Fees

Index funds advertise their fees by listing their expense ratio. An expense ratio tells you the percentage of the fund’s assets that a brokerage uses to cover operational expenses. The lower the expense ratio, the more of your money you get to keep as an investor. Because index funds don’t have to pay as many people to manage the fund, they can afford to charge lower fees. That’s good news for the investor, since fees can eat into your investments.

When researching index funds, you may also notice the term “no-load,” which indicates that the fund doesn’t charge a commission when you buy or sell shares. Lower transaction costs can help more of your money stay invested, making fees and expense ratios worth comparing when choosing among available options.

Diversification

Another reason index funds are popular is that they’re diversified. Index funds track so many companies that they come with significant built-in diversification. More diversification means you run a lower risk that if one company (or sector) falls, your investments will fall along with it.

Index funds take care of some of the work of diversifying your investments. You don’t have to research hundreds or thousands of individual companies, you just have to invest in an index fund and you’ll track that market. However, even die-hard index fund fans tend to own more than one. You can buy a domestic stock market index fund, an international stock index fund, a bond index fund or an international bond index fund, and allocate your resources according to your risk tolerance.

Tax Efficiency

In addition to their low fees and diversification, index funds tend to generate less taxable income than actively managed funds do. That’s because, since they’re passively following the market, index funds don’t buy and sell as frequently. Fewer sales means less taxable income for the investor. And who doesn’t like the sound of lower taxes?

Outperformance vs. Active Funds

Over the past decade, passively managed U.S. equity funds have outperformed active managers across nearly all major categories, according to Morningstar’s Midyear 2025 US Active/Passive Barometer. ¹

In large caps, passive large-blend funds returned 13.3% annually on an asset-weighted basis vs. 11.9% for active funds, while passive large-growth funds led by an even wider margin (16.9% vs. 14.6%), according to Morningstar. Ten-year success rates told a similar story: only 5.8% of active large-blend funds, 16.3% of large-value funds and 2.8% of large-growth funds managed to beat their passive peers over 10 years.

Mid-cap and small-cap segments were somewhat closer, yet passive funds still held an overall performance edge, underscoring how difficult it has been for active managers to consistently generate better net returns in U.S. equities.

Potential Downsides of Investing in Index Funds

While index funds offer many benefits, it’s important to note that they’re not perfect. One of the potential downsides of investing in an index fund is the lack of control over the underlying investments. Because index funds are designed to track a particular market index, investors don’t have a say in which individual stocks or bonds the fund holds.

Another potential downside is the possibility of underperformance during market downturns. While index funds aim to track the performance of the underlying index, they can still experience losses during market downturns.

Finally, while index funds offer diversification benefits, they’re not immune to market risk. In a market downturn, all stocks in the index will likely experience losses, including those held in the index fund.

Index Funds and the Efficient Market Hypothesis

Supporters of index funds often point to the Efficient Market Hypothesis (EMH), which argues that financial markets quickly incorporate new information into stock prices. Under this view, publicly available data is already reflected in a security’s value, leaving little room for investors to gain an edge by hunting for hidden bargains or timing the market.

Because EMH suggests that consistently outperforming a broad index is unlikely, index funds take a simpler path by mirroring the market instead of trying to outguess it. This approach helped shape the rise of passive investing, which trades less frequently and focuses on tracking long-term market trends rather than reacting to short-term signals.

The first index funds faced doubts from investors who were accustomed to stock picking and active management. Over time, however, their low costs, transparency and steady performance relative to active funds contributed to their widespread acceptance across retirement plans and brokerage accounts.

Bottom Line

Some people make investing their hobby, and derive serious enjoyment from researching and trading stocks. But hey, that’s not for everyone. Others are happy to pay financial advisors for the convenience of not having to think about their investing. And if they can afford it, more power to them. But if you want a low-maintenance, low-cost way to invest your money, for retirement, for a home purchase or for any other financial goal, it can be a good idea to look into index funds. You’ll have the satisfaction of knowing that more of your money is growing and less is going to pay fees. It’s not a flashy approach to investing, but it can be a solid one.

Investing Tips

• If you have a more complex financial situation or just prefer talking face-to-face, consider working with a traditional financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you don’t have a lot to invest, you might want to consider a robo-advisor. Robo-advisors, which are entirely online, offer lower fees and account minimums than traditional financial advisors.

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