What Is Index Funds?

There are indexes and index funds available for various parts of the financial market. Index funds mirror the assets and weights of a specific index, such as stocks or bonds. If you want to invest in a particular economic sector or the overall market, you can choose indexes that closely follow the benchmark index you’re interested in. Index funds follow a passive investing approach to minimize trading and reduce expenses.

Index funds take care of the work for you when it comes to broad indexes like the S&P 500. Instead of trying to do it yourself, these funds hold a representative sample of the securities. The S&P 500 index funds, which are highly favored in the U.S., mirror the movements of the stocks in the S&P 500. This index covers approximately 80% of all U.S. equities based on market capitalization.

Index funds’ portfolios see significant changes only when their benchmark indexes change. If the fund tracks a weighted index, its managers may adjust the weights and components of their securities to align with the target index on a regular basis.

Apart from the S&P 500, these funds track other important indexes such as the Nasdaq Composite Index, which includes 3,000 stocks on the Nasdaq exchange; the Bloomberg U.S. Aggregate Bond Index, which monitors the entire U.S. dollar-denominated bond market; and the Dow Jones Industrial Average (DJIA), made up of 30 large-cap companies selected by the Wall Street Journal editors.

Index funds offer a wide range of market exposure and diversification across different sectors and asset classes based on their underlying index. These funds are generally effective in minimizing tracking errors, which is the variance between the fund’s performance and the target index. However, it is important to carefully assess the fees and performance of any fund before making an investment. As an example, Fidelity’s Nasdaq Composite Index Fund (FNCMX) had an average annual return of 15.16% over a 10-year period, slightly lower than the Nasdaq composite’s return of 15.23%, with a difference of 0.07%.


Index funds have lower fees compared to actively managed funds. Many investors wonder why they are paying higher fees to fund managers if actively managed funds can’t beat passive funds. According to SPIVA data, 87% of actively managed funds performed worse than the S&P 500 in the last five years. Over a 15-year period, this number increases to 92%.

Understanding statistics like these helps to explain why passive funds, mostly index funds, are becoming more popular. Passive funds charge an expense ratio as a percentage of assets under management to cover various costs like advisor fees, transaction fees, taxes, and accounting expenses. Index fund managers do not need research analysts to choose stocks or time trades since they replicate benchmark index performance. They also trade less frequently, resulting in lower transaction fees. In contrast, actively managed funds have higher costs due to larger staff, more complex trades, and higher trading volumes.

Index funds usually have lower fees than actively managed funds. The fees for index funds are usually around 0.05% or even lower, while actively managed funds can charge fees of around 0.44% to over 1.00%, depending on the assets.

Here are a few more benefits of these funds:

  • Lower costs
  • Market representation
  • Transparency
  • Historical performance
  • Tax efficiency


Index funds have been criticized for their lack of flexibility. Since they are designed to mimic a specific market, they lose value when the market declines and cannot adjust in an unfavorable situation. Additionally, they are also criticized for including all the securities in an index automatically. This means they may invest in overvalued or weak companies, neglecting the opportunity to invest in assets that could potentially yield higher returns and be chosen by a fund manager. However, this automated approach has often outperformed active management, possibly because it holds onto assets that active fund managers have misjudged.

One drawback is related to market-cap weighting, which is commonly used by index funds. In these funds, companies with larger market capitalizations have a stronger impact on the fund’s performance. This focus on a few big companies can increase your risks if these companies perform poorly.


Index funds are a popular choice for investors who want low-cost, diversified, and passive investments that can outperform many higher-fee, actively traded funds. They aim to mimic the performance of financial market indexes, like the S&P 500, and are great for long-term investing, such as in retirement accounts. While they offer advantages like lower risk through diversification and consistent long-term returns, index funds are also affected by market fluctuations and lack the flexibility of active management. Despite these limitations, index funds are often preferred for their reliable performance and are now commonly included in investment portfolios. It’s important to consider your investment goals and risk tolerance when selecting an index fund. Seeking personalized advice from a financial advisor is always a wise decision.