What is an Index Fund, and How Does It Work?

Investing

Aug 4

What is an index fund graphic Vision Retirement fiduciary RIA financial advisor CFP certified financial planner Ridgewood NJ Poughkeepsie NY

Index funds have become more popular as an investment option and are now widely regarded as one of the most successful innovations in modern financial history; but what makes them so attractive? Explore how exactly they operate and why they’re favored by novice and seasoned investors alike.

What is an investment fund?

Before we dive into index funds, let’s take a step back and discuss investment funds in general. All funds work by pooling a collection of money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets: a literal manifestation of the popular adage telling you not to “put all your eggs in one basket.”

Let’s say you have $200 to invest, for example, not enough to buy even one share of Apple ($202.38 as of 8/4/25). If you invest this amount in an index fund tracking the S&P 500, you’re likewise investing in a small portion of all 500 companies in the S&P (including Apple)—instant diversification!

What often makes investment funds confusing, however, is that an index fund may exist as a mutual fund or exchange-traded fund (ETF); but not all mutual funds nor ETFs are index funds (similar to how all squares are rectangles but not all rectangles are squares). With this in mind, here’s a quick refresher on mutual funds and ETFs for the sake of clarification.

Mutual funds

A mutual fund is a basket of securities with shares bought and sold at the end of the trading day at the net asset value (NAV).

Exchange-traded funds (ETFs)

Similar to a mutual fund, an exchange-traded fund (ETF) trades on stock exchanges just like an individual stock—meaning investors can buy and sell shares throughout the trading day—and typically have lower expense ratios (fees and other expenses) than mutual funds. Now on to index funds…

What is an index fund?

An index fund is a type of mutual fund or ETF designed to track the performance of a specific market index. Rather than trying to outperform the market via active management, index funds aim to mirror returns of the index they follow by holding the same stocks or securities in the same proportions (known as “passive management”). Fees are typically lower compared to actively managed funds given no need for a fund manager to research/choose stocks, with this cost efficiency making them a popular choice among long-term investors looking to maximize returns while minimizing expenses.

The instant, easy, low-cost diversification associated with index funds is a huge benefit for novice and experienced investors alike and bucks the trend when it comes to the relationship between investing risk and reward. While it’s generally the case that the higher the potential investment returns, the higher the risk (e.g., bonds are typically considered safer than stocks but also known to have lower returns), diversification is one of few exceptions to the rule as it decreases risk but without the cost of lower returns: a huge index fund benefit.

Passive vs active management

While we briefly touched on active vs passive management, the concept deserves a bit more discussion as a key index fund differentiator. As a reminder, active investment management involves a hands-on approach whereby fund managers or individual investors try to outperform the market by selecting specific stocks, bonds, or other assets: relying on market research, financial analysis, and economic forecasts to make buying and selling decisions. Active managers likewise adjust their portfolios frequently to capitalize on market trends, undervalued securities, or economic conditions. On the other hand, passive investment management aims to match the performance of a specific market index rather than try to beat it. You may wonder why anyone would choose this route—why not try to exceed performance instead? A few reasons come to mind here…

First, active managers aim to outperform the index they track; but even experienced managers can find it difficult to consistently beat the market and thus underperform as a result. An index fund, meanwhile, tracks an index and therefore can’t underperform it (so long as it’s tracking accurately). Actively managed funds also typically have higher expense ratios due to research, more frequent trading, and management fees whereas passively managed index funds often have fewer fees and expenses than a traditional mutual fund—though simultaneously may not see the potential returns of an actively managed mutual fund.

So, which strategy is better? It all depends on what you’re looking for and is by no means an “either/or” scenario. Investors can also decide to invest in both an actively managed mutual fund and index fund if they so choose.

Types of index funds

While broad market index funds are the most well-known, investors have many options at their disposal when it comes to index-based investing—allowing them to target specific market segments or investment strategies. Index funds can track a wide range of indices, including those based on specific sectors, market capitalizations, geographical regions, and investment strategies. Some of the most common types include…

Broad market index funds

These funds track indices that represent the overall market. The Total Stock Market Index Fund, for example, aims to reflect the entire U.S. stock market including small-, mid-, and large-cap stocks.

Sector index funds

These funds track indices focused on specific industries such as technology, healthcare, or energy.

International and global index funds

Some index funds focus on non-U.S. markets either by tracking entire international markets or specific regions.

Bond index funds

While most index funds track stock indices, some track bonds: spanning a mix of government, corporate, and mortgage-backed securities or otherwise focusing on specific bond types (e.g., Treasury or municipal bonds).

Small-cap and mid-cap index funds

Rather than tracking the entire market, these funds focus on companies of a specific size.

Do index funds pay dividends?

Growth and dividends represent two ways to earn money through stocks. If you’re an investor interested in the latter, can you still invest in index funds? You bet, as many indeed pay dividends.

Broad market index funds, such as those tracking the S&P 500, hold many dividend-paying companies. While not all stocks in these indices pay dividends, a good portion do and thus offer regular payouts to investors. Dividend-focused index funds are also in the mix, specifically targeting high-dividend-paying stocks.

When an index fund holds dividend-paying stocks, dividends received may be paid out to investors or reinvested automatically—with many funds distributing dividends on a quarterly or annual basis so investors can receive these payments as cash or otherwise reinvest them to buy additional fund shares. Some funds also offer automatic dividend reinvestment, meaning they use the dividends to buy more shares on behalf of investors without requiring any action on their part.

Index fund dividends are taxed as either qualified or ordinary income, depending on how long the fund has held the underlying stocks; qualified dividends are taxed at a lower rate, while non-qualified dividends are taxed as ordinary income.

How to invest in an index fund

Want to invest in an index fund? Here are the steps you’ll need to take…

1. Choose an index to track

You’ll first need to decide which index to follow. Want to track a broad market index such as the Dow Jones or S&P 500? Or perhaps you’d prefer an index specializing in one defined area such as international stocks or small-cap companies? How about a combo of both? The answer ultimately depends on your unique financial situation including your goals, time horizon, and risk tolerance.

2. Select an index fund

After choosing an index, you’ll need to select a fund that tracks it. Many brokerage firms indeed offer a variety of index funds; consider factors such as expense ratios, minimum investment requirements, and historical performance when comparing them.

3. Open an investment account

To purchase an index fund, you’ll need an investment account (e.g., a brokerage account). Many online brokers offer commission-free trading, making it easy to invest. Saving for retirement? Consider using tax-advantaged accounts to maximize long-term gains.

4. Decide how much to invest, maintaining diversification

Investors can start with a lump sum investment or use dollar-cost averaging, which involves investing a fixed amount at regular intervals to help smooth out market fluctuations over time.

5. Monitor and rebalance periodically

Although index funds require little active management, it’s important to review your portfolio periodically as market movements can shift your asset allocation over time; rebalancing ensures your investments continue to align with your financial goals and risk tolerance. If equities have grown to dominate your portfolio, for example, shifting some assets into bonds or other investments can help strike the balance you need.

While index funds offer more diversification than individual stocks, they still primarily focus on equities or sometimes a specific equity type (U.S. stocks, for example). To build a well-balanced portfolio, investors should consider diversifying across different-sized companies, geographic regions, and asset classes.

In sum: are index funds a good investment?

Investing is not a one-size-fits-all endeavor. While index funds—ideal for investors who prefer a hands-off approach and want to build wealth steadily over time—may not deliver the highest short-term gains, their diversification, low fees, and robust long-term potential make them a cornerstone of many investment portfolios.

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