Definition
An index fund is a mutual fund or ETF that aims to match the return of a market index by holding the same securities, or a representative sample, in roughly the same proportions.
How it works
An index is a rule-based list of securities, such as the largest companies in a country, with a method for weighting them. An index fund follows that list instead of having managers pick stocks they expect to do well, an approach called passive investing. Because the fund trades mainly when the index changes or when money flows in and out, its costs are usually lower than those of actively managed funds. It can be a mutual fund, usually bought and sold once a day at net asset value, or an ETF that trades during the day.
Many popular indexes are weighted by market cap, so the largest companies receive the most money. A few big companies can then drive a large share of the fund's return. Other indexes weight companies equally or by factors such as dividends, which changes the result.
No index fund matches its index perfectly. Fees, trading costs, cash held for withdrawals and sampling create a gap between the fund's return and the index return, often called tracking difference. How much that gap varies over time is called tracking error. An index fund also carries the full ups and downs of the market it tracks: it removes the risk of picking the wrong stock, not the risk of the whole market falling.
Example (hypothetical numbers)
Suppose an index holds only 3 companies: Company A with a market cap of $6,000,000,000, Company B with $3,000,000,000 and Company C with $1,000,000,000.
Total = $10,000,000,000, so the weights are $6,000,000,000 ÷ $10,000,000,000 = 60%, 30% and 10%.
A $5,000 investment in a fund tracking this index is split into $3,000, $1,500 and $500.
If the index returns 8.0% in a year and the fund returns 7.8% after costs, the tracking difference is 0.2 percentage points.
The largest company drives most of the result, and costs make the fund trail its index slightly.
Common mistakes
- Assuming a market-cap-weighted index fund spreads money evenly across all companies.
- Believing an index fund cannot lose much value because it holds many stocks.
- Comparing index funds only by past returns while ignoring fees and tracking difference.
Related calculators
This glossary is for education only and is not investment advice. Examples use hypothetical numbers.