What Is an Index Fund and How Does It Work? — Tally (2024)

This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.

For newcomers to the world of investing, expert advice often tells you to “invest in index funds” instead of picking stocks. But what does this really mean? What is an index fund, and how does it work?

This article will break down everything that you need to know about index funds, from the basic definition to how you can actually invest in these funds.

What is an index fund?

What is an index fund, and how does it work?

An index fund is a financial product that aims to track the price of a certain financial index.

Financial indexes like the Standard and Poor's 500 (S&P 500) or the Dow Jones Industrial Average (DJIA) are set up to track the stock prices of a basket of companies from within that index. For instance, the S&P 500 tracks the prices of 500 of the largest publicly traded companies in America.

An index fund is a financial product that tracks the underlying index. An S&P 500 index fund, such as SPY, tracks the actual S&P 500 index.

The end result is an index fund that can be invested in by anyone, and that tracks the actual performance of the underlying index.

When you buy an index fund, you are essentially buying very small pieces of each company included in that index. Buying an S&P 500 index fund — like FXAIX or SPY — can be done through any investment account, and is much easier than actually buying each underlying stock.

How index funds work

To track the underlying index, fund managers buy stocks in each company that is included in the index — in the amount proportional to that company’s share of the index. They use a strategy known as “market cap weighting.” This means that the more valuable a company, the more weight it is given in the index.

For instance, the “Big Five” tech stocks (Apple, Amazon, Microsoft, Alphabet and Meta) now make up around 20% of the S&P 500 index. So even though there are 500+ firms in the S&P 500, the top handful of companies make up a large percentage of the overall index.

For example, a fund tracking the S&P 500 would purchase shares in all 500+ of the companies included in the index. But the fund would buy many more shares of companies like Apple, Microsoft and Walmart than they would of smaller firms like AutoZone or Chipotle.

Index funds are passively managed, which means that the management companies that offer them do not try to time the market or employ advanced strategies. They will buy and sell holdings occasionally, but only to keep the fund aligned with the underlying index.

Different types of index funds

There are different styles of index funds that can be invested in.

Index funds can be one of two different structures:

  • Mutual funds

  • Exchange traded funds (ETFs)

The main difference between mutual funds and ETFs is that ETFs trade like stocks, and can be bought and sold at any time during trading hours. Mutual funds, on the other hand, can only be purchased once at the end of each trading day.

Beyond the mutual fund vs. ETF distinction, index funds can also track all sorts of different underlying indexes and types of stocks. Because of this, you can invest in index funds that track things like:

  • The US large cap index (the largest companies in America)

  • The US small cap index (smaller publicly traded companies in America)

  • International indexes (the total stock market outside of America)

  • Specific-country indexes, such as the Japanese stock market or the German small-cap stock market

Index funds can be set up to track any underlying index, and there are hundreds of different indexes.

The most popular, however, are large-cap stock market indexes such as the S&P 500. In fact, 9 out of 10 of the top index funds by size are either large-cap stock indexes or total market indexes.

How to invest in index funds

You can invest in index funds in most investment accounts, including a 401(k), Roth IRA or a standard taxable brokerage account.

Most index funds are structured as ETFs, which means that you can buy them just like you would a normal stock. Simply type in the fund’s ticker symbol (SPY or FXAIX, for example), and purchase shares in the ETF.

As for which index funds to buy, it’s best to talk to a qualified investment advisor to structure an investment plan that works for you. You can also look online for some of the best index funds.

When investing in an index fund, be sure to pay attention to any investment fees that may be involved. This includes any upfront fees, as well as ongoing management fees (known as the expense ratio).

Upfront fees, such as trading commissions, are charged by the broker. The fees you pay will depend on where you hold your investments. Fortunately, many brokers now offer commission-free trading.

Ongoing investment management fees are automatically subtracted from the performance of the fund, and are charged by the company that actually manages the index fund. Most broad index funds have very low fees — FXAIX charges just 0.015% per year, while SPY charges 0.09% per year.

This means that on a $10,000 investment, FXAIX would cost you $1.50 per year, while SPY would cost $9 per year.

Index funds typically have much lower fees than mutual funds and other actively managed investment funds. As long as you choose broad index funds with relatively low fees, the fees you pay shouldn’t significantly affect the performance of your investments.

Learn more about the basics of investing in our Investing 101 guide.

Index funds for passive investing

Index funds are a great, low-cost way to implement passive investment strategies in your portfolio.

You may have read about “passive investing” strategies before. Essentially, this concept states that investors should buy index funds and utilize a “set it and forget it” approach to investing.

Passive is the opposite of active. In active investing, individuals may buy specific stocks or assets, sell others, and attempt to time short-term swings in the market.

Passive investing is a simpler approach. You simply buy index funds and keep buying index funds until you’re ready to retire. You don’t attempt to time the market, pick winning stocks or utilize any advanced strategies. You simply buy into broad index funds, then wait.

While this approach may sound boring, it’s quite effective. It’s exceptionally difficult to consistently pick individual investments that beat the market — so the best strategy for most people is to simply buy into the stock market using index funds.

In fact, most professional investors and hedge funds actually underperform the stock market. This means that the majority of professional investors would be better off simply buying index funds.

Mastering your finances

Now that you’re armed with knowledge surrounding the question of “what is an index fund,” why not learn more about personal finance? Check out the Tally blog.

We have many useful informational resources on paying off debt, mastering credit, and managing your money.

And if you have credit card debt currently, be sure to look into Tally†. Tally is a personal finance app offering a lower-interest line of credit that may help qualifying Americans get out of credit card debt faster. Learn how Tally works here.

†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.

I'm a seasoned investor with a deep understanding of financial markets and investment strategies, particularly when it comes to index funds. Let's delve into the concepts introduced in the article you provided:

  1. Index Fund: An index fund is a type of investment vehicle that aims to replicate the performance of a specific financial market index, such as the S&P 500 or the Dow Jones Industrial Average. By investing in an index fund, investors gain exposure to a diversified portfolio of securities that mirror the composition of the chosen index.

  2. Financial Index: A financial index is a statistical measure of the changes in a portfolio of stocks representing a portion of the overall market. Examples include the S&P 500 and the Dow Jones Industrial Average. These indexes serve as benchmarks for investors to gauge the performance of the broader market or specific sectors.

  3. Mutual Funds vs. ETFs: Index funds can be structured as either mutual funds or exchange-traded funds (ETFs). Mutual funds are bought and sold once a day at the net asset value (NAV), while ETFs trade on exchanges throughout the day like individual stocks. ETFs offer intraday trading flexibility, while mutual funds may have minimum investment requirements.

  4. Market Cap Weighting: Market capitalization (market cap) weighting is a method used by index fund managers to determine the weight of each constituent stock in the index based on its market capitalization. Companies with higher market capitalizations exert more influence on the index's performance.

  5. Passive Management: Index funds are passively managed, meaning they aim to replicate the performance of the underlying index rather than actively selecting investments. This approach typically results in lower management fees compared to actively managed funds, as there is less need for research and decision-making.

  6. Types of Index Funds: Index funds can track various types of indexes, including those focused on large-cap stocks, small-cap stocks, international stocks, or specific-country markets. The choice of index fund depends on an investor's investment objectives, risk tolerance, and market outlook.

  7. Investment Process: Investing in index funds is relatively straightforward and can be done through various investment accounts such as 401(k) plans, Roth IRAs, or brokerage accounts. Investors can purchase shares of index funds using their ticker symbols, and fees associated with index funds, such as expense ratios and trading commissions, should be considered.

  8. Passive Investing: Index funds are commonly associated with passive investing strategies, where investors seek to achieve market returns over the long term without trying to beat the market through active trading or stock selection. Passive investing advocates a disciplined, low-cost approach to wealth accumulation by harnessing the power of broad market exposure.

Understanding these concepts lays a solid foundation for navigating the world of index fund investing and implementing sound investment strategies aligned with one's financial goals.

What Is an Index Fund and How Does It Work? — Tally (2024)
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