Index fund

Before you rely on it

What to check

Read which index it tracks, and how closely.

The common error

Where people go wrong with index fund

Assuming similar names mean similar holdings. Two funds with nearly identical titles can track markets that differ substantially in concentration, sector weighting and geography.

Worked through

Index fund in plain numbers

A total-market index fund holds thousands of stocks in proportion to their size. Buy $10,000 of it and you own a sliver of every company in the index at once; the fund does not try to pick winners. It buys and sells only when the index changes. With no research team and little trading, its cost can be very low: an expense ratio of 0.03% is $3 a year on $10,000. An actively managed fund charging 0.90% takes $90. The difference must be earned back through better stock picking before the active fund even matches the index, and most do not manage it over long periods.

Easily confused

Index fund and its neighbours

An index fund is not the same as an exchange-traded fund, though many index funds are ETFs. Index describes the strategy, tracking a published benchmark. ETF describes the wrapper, which trades on an exchange like a share. Mutual funds can be index funds too. It is also different from an actively managed fund, which tries to beat a benchmark, and from a target-date fund, which may hold index funds inside; a fund with index in its name does not always track a plain market-cap index, so check what it holds.

In real decisions

Where index fund turns up

Investors use index funds as core holdings in retirement accounts, college savings and taxable portfolios. Employer plans offer them as default choices. They suit people who want broad exposure at low cost without choosing individual stocks; advisors build portfolios from a few index funds across stocks and bonds. Comparing several index funds means looking at the expense ratio, the index tracked, the tracking difference and tax efficiency.

Know the edges

Where index fund stops being reliable

An index fund follows the market down as well as up; it carries the risks of its index, including concentration in the largest companies. It cannot avoid overvalued stocks or sectors. Small differences among funds tracking the same index exist. Tax treatment varies by structure and account. It is not risk-free and does not guarantee returns. Choose an index that fits your goals and time horizon and keep costs low.

Quick answers

What people ask about index fund

Is an index fund the same as an ETF? No. An index fund is a strategy. An ETF is a way of holding a fund that trades on an exchange. Many index funds are ETFs, and many are ordinary mutual funds.

Do index funds ever lose money? Yes. They follow their index down as well as up. Diversification lowers the risk of a single stock but not of the market.

How many index funds do I need? Many investors use two or three: a broad stock fund, an international fund and a bond fund. Fewer can also work.

What is tracking error? The gap between the fund's returns and its index. Small differences come from fees and trading. Compare it across funds tracking the same index.