The short answer
An index fund is an investment fund that buys all, or a representative sample, of the companies in a market index, such as the S&P 500 (500 large US companies) or the FTSE All-World (thousands of companies worldwide). Instead of trying to pick winners, it simply owns the market.
Because nobody is paid to pick stocks, index funds are cheap, often charging a fraction of a percent a year. Over decades, low cost and broad diversification have made them hard to beat, which is why they are a common default for long-term investors.
How an index fund works
- An index is a list of companies chosen by a rule, such as "the 500 largest US companies", weighted by size.
- The fund buys those companies in the same proportions.
- When the index changes, the fund adjusts automatically.
- You buy units or shares in the fund, so a single purchase gives you a small piece of every company in it.
If the index rises 8 percent in a year, the fund rises by about 8 percent, minus its small fee.
Why fees matter so much
Fees are taken every year, and they compound. Look at 10,000 invested for 30 years at a 7 percent annual return before fees:
| Annual fee | Return after fees | Value after 30 years |
|---|---|---|
| 0.05% (typical large index fund) | 6.95% | about 75,060 |
| 1.00% (typical actively managed fund) | 6.00% | about 57,430 |
The higher fee costs about 17,600, nearly double the original investment, for the same underlying market return. Most actively managed funds also fail to beat their index over long periods once fees are counted, according to long-running studies such as S&P's SPIVA reports.
The fee to look for is called the expense ratio or ongoing charges figure (OCF).
Index mutual funds vs ETFs
Both can track the same index. The difference is how you buy them.
| Index mutual fund | Index ETF | |
|---|---|---|
| How it trades | Bought and sold once a day at the closing price | Trades on a stock exchange throughout the day |
| Minimum | Sometimes a minimum investment | The price of one share, or less with fractional shares |
| Fees | Often very low | Often very low |
| Best for | Automatic monthly investing | Flexibility, any brokerage account |
For a long-term investor buying regularly, the choice matters less than keeping fees low and staying invested.
Common indexes
- S&P 500: about 500 large US companies.
- Total US market: thousands of US companies, large and small.
- MSCI World / FTSE Developed: large companies in developed countries.
- FTSE All-World / MSCI ACWI: developed and emerging markets together.
- Bond indexes: government and corporate bonds, which usually fall less than shares in a crash.
- National indexes: such as the FTSE 100 (UK), Nifty 50 (India) or KSE-100 (Pakistan). A single-country index is less diversified.
The risks to understand
- Market risk. Index funds fall when the market falls. Global stock markets have dropped by a third or more several times in recent decades, and recovery has sometimes taken years.
- Concentration. Market-weighted indexes put more money into the biggest companies. In recent years a handful of large US technology firms made up a large share of the S&P 500.
- Currency risk. A fund in a foreign currency rises and falls with exchange rates.
- Behaviour risk. The biggest danger is selling in a panic. Index investing works only if you stay invested through downturns.
How to buy your first index fund
- Have an emergency fund first, so you never have to sell in a hurry. See how much to keep in an emergency fund.
- Use a tax-advantaged account if your country offers one, such as a 401(k) or IRA in the US, an ISA or pension in the UK, or a voluntary pension scheme elsewhere.
- Choose a low-cost platform and compare account and trading fees.
- Pick a broad fund: a global or total-market fund is a simple core holding. Check the expense ratio.
- Invest automatically every month, which smooths out the ups and downs.
- Reinvest dividends (or choose an accumulating fund).
- Leave it alone. Check once or twice a year, not every day.
Our beginner's guide to investing covers accounts and asset allocation in more detail, and compound interest explained shows why time is the key ingredient.
Key takeaways
- An index fund owns a whole market index, so you get broad diversification in one purchase.
- Low fees are the main advantage, and they compound over decades.
- Index funds still fall in market crashes; invest money you can leave for years.
- Buy regularly, reinvest dividends and avoid panic selling.
This article is general information, not personal financial advice. Investments can fall as well as rise. Consider your own circumstances or speak to a qualified adviser.