Index Fund
What is Index Fund?
An index fund is a fund that passively tracks a market index, such as the S&P 500, rather than picking stocks actively.
Because it just mirrors the index, it has very low fees and tends to match the market's return. Decades of evidence show low-cost index funds beat most actively managed funds after fees.
Index Fund: a worked example
Two investors each put in $10,000 and leave it for 30 years. Assume the market itself returns 7% a year before costs. The index fund charges 0.05%, so its holder earns about 6.95%. The active fund charges 1.05% and, matching the market before fees, earns about 5.95%. Compounding $10,000 at 6.95% for 30 years gives roughly $75,060. At 5.95% it gives roughly $56,630. Same market, same starting sum, same holding period, and a gap of about $18,430 created entirely by one percentage point of annual fee.
The mistake students make with index fund
Calling index fund returns merely average treats average as mediocre. Because the index return is the pre-fee average of everyone who owns those stocks, every dollar beating it is matched by a dollar trailing it, and both sides then pay their costs. Taking that average at near-zero cost therefore lands you above most actively managed dollars, not in the middle of them. The other error is hearing index and thinking safe. An index fund falls exactly as far as its index does.
Index Fund questions
What is the difference between an index fund and an ETF?
An index fund is a strategy, tracking a published index rather than picking stocks, while an ETF is a structure, a fund whose shares trade on an exchange all day. The two overlap constantly because most large ETFs are index funds, but an index fund can also be a mutual fund priced once daily, and an ETF can be actively managed. What it tracks and how it trades are two separate questions.
Why do index funds have lower fees?
Index funds charge less because copying a published list needs no research analysts and few trades. The fund buys what the index holds in the weights the index specifies, and only trades when the index changes or when new money arrives. That low turnover also holds down trading costs and taxable distributions, so the real cost advantage over an active fund is wider than the two expense ratios alone suggest.
Can an index fund beat the market?
An index fund cannot beat the index it tracks, by design; the best it can do is match that index minus a small fee and a small tracking difference. What it routinely beats is the typical actively managed fund, because those funds collectively own the same market while paying far more in fees and trading costs. Beating the market and beating most other investors are two different targets.
Related terms
Common comparisons
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