Index funds are the most recommended investment for most people — endorsed by Warren Buffett, preferred by Nobel Prize-winning economists, and used by the majority of the world’s largest pension funds. If you have heard you should invest in index funds but are not sure exactly what they are or how they work, this guide explains everything you need to know.
What Is an Index Fund?
An index fund is a type of investment fund (either a mutual fund or an ETF) that tracks a market index — a predefined list of stocks, bonds, or other securities. Instead of a fund manager picking stocks, the fund simply buys all (or a representative sample) of the securities in the index, in the same proportions.
The most commonly tracked index is the S&P 500, which includes 500 of the largest publicly traded U.S. companies. An S&P 500 index fund owns a small piece of all 500 companies — Apple, Microsoft, Amazon, Google, Berkshire Hathaway, and hundreds more.
How Index Funds Work
When you buy shares of an index fund, you become a part-owner of all the companies in that index, proportionally. If the index goes up 10%, your investment goes up approximately 10% (minus a very small fee). If Apple’s share of the S&P 500 grows because Apple’s market value increases, the fund automatically holds more Apple without any manager making a decision.
This passive management is the key feature. No one is actively buying and selling to try to beat the market — the fund just mirrors it.
Index Funds vs. Actively Managed Funds
Actively managed funds employ portfolio managers who research companies, time the market, and attempt to outperform an index. In theory, this sounds better. In practice, the data is clear:
- Over 15 years, approximately 88-92% of actively managed large-cap funds underperform the S&P 500 (SPIVA data).
- Active funds charge much higher fees — often 0.5% to 1.5% annually versus 0.03% to 0.10% for index funds.
- Higher fees compound into massive differences over decades. A 1% fee difference on $100,000 over 30 years costs approximately $200,000 in lost returns.
Types of Index Funds
- Total stock market index funds: Track the entire U.S. stock market, including small, mid, and large cap companies. Example: Vanguard Total Stock Market Index Fund (VTI).
- S&P 500 index funds: Track the 500 largest U.S. companies. Example: Fidelity ZERO Large Cap Index Fund (FNILX) with a 0% expense ratio.
- International index funds: Track stocks in developed markets outside the U.S. Example: Vanguard FTSE Developed Markets ETF (VEA).
- Bond index funds: Track a basket of bonds for income and stability. Example: Vanguard Total Bond Market ETF (BND).
- Target-date funds: A mix of stock and bond index funds that automatically shifts to a more conservative allocation as you approach retirement.
What Is an Expense Ratio?
The expense ratio is the annual fee charged by the fund, expressed as a percentage of your investment. A 0.04% expense ratio means you pay $4 per year on a $10,000 investment. Look for index funds with expense ratios under 0.10% — Fidelity, Vanguard, and Schwab all offer funds in this range. Some Fidelity ZERO funds have a 0% expense ratio.
How to Buy an Index Fund
- Open a brokerage or IRA account (Fidelity, Vanguard, Schwab, or a robo-advisor like Betterment).
- Fund your account with a bank transfer.
- Search for the fund by name or ticker symbol.
- Buy shares with a market or limit order (for ETFs) or invest a dollar amount (for mutual funds).
- Set up automatic contributions to invest consistently.
Bottom Line
Index funds offer broad market diversification, extremely low fees, and historically strong long-term returns — without requiring stock-picking skill or constant monitoring. For most investors, a simple three-fund portfolio of a total U.S. stock market fund, an international stock fund, and a bond fund covers everything needed. Start with low-cost index funds in a tax-advantaged account (Roth IRA or 401(k)) and let compounding do the work.