What Is Index Fund?

Definition

Index fund is a type of investment fund that aims to track the performance of a specific stock market index, such as the S&P 500, by holding a portfolio of stocks that replicates the index, a concept first introduced by Vanguard's John Bogle in 1976.

How It Works

Index funds work by pooling money from investors to purchase a representative sample of stocks or bonds that make up the underlying index, thereby allowing individuals to invest in a broad range of assets with a single investment. The net asset value (NAV) of an index fund is calculated by dividing the total value of the fund's assets by the number of outstanding shares, with Vanguard's Total Stock Market Index Fund holding ~3,000 stocks (Vanguard annual report). Index funds typically use a passive management approach, which means that the fund manager does not attempt to beat the market by actively buying and selling securities, but instead focuses on tracking the underlying index, resulting in lower expense ratios, such as the 0.04% expense ratio of the Schwab U.S. Broad Market ETF (Schwab annual report).

The performance of an index fund is closely tied to the performance of the underlying index, with the fund's tracking error measuring the degree to which the fund's returns deviate from the index's returns, such as the 0.05% tracking error of the iShares Core S&P Total U.S. Stock Market ETF (iShares annual report). Index funds can be used to invest in a wide range of asset classes, including domestic stocks, international stocks, and bonds, with the iShares Core U.S. Aggregate Bond ETF tracking the Bloomberg Barclays U.S. Aggregate Bond Index (iShares annual report). By investing in an index fund, investors can gain diversification benefits, as the fund's portfolio is spread across a large number of securities, reducing the risk of any one security's performance affecting the overall portfolio, such as the ~500 stocks held by the SPDR S&P 500 ETF Trust (SPDR annual report).

Index funds can be traded on an exchange like individual stocks, allowing investors to buy and sell shares throughout the day, with the trading volume of the Vanguard Total Stock Market Index Fund averaging ~1 million shares per day (Vanguard annual report). This flexibility, combined with the fund's ability to track a specific index, makes index funds a popular choice for investors seeking a low-cost, low-maintenance investment option, such as the ~$1 trillion in assets held by the Vanguard Total Stock Market Index Fund (Vanguard annual report).

Key Components

• Index: the specific stock market index that the fund aims to track, such as the S&P 500 or the Dow Jones Industrial Average, with the S&P 500 consisting of ~500 large-cap stocks (S&P Dow Jones Indices).
• Portfolio: the collection of stocks or bonds held by the fund, with the iShares Core S&P Total U.S. Stock Market ETF holding ~3,000 stocks (iShares annual report).
• Expense ratio: the fee charged by the fund manager to cover administrative and operational costs, with the Schwab U.S. Broad Market ETF having an expense ratio of 0.03% (Schwab annual report).
• Tracking error: the degree to which the fund's returns deviate from the index's returns, with the Vanguard Total Stock Market Index Fund having a tracking error of 0.01% (Vanguard annual report).
• Diversification: the spreading of investments across a range of asset classes to reduce risk, with the iShares Core U.S. Aggregate Bond ETF holding ~8,000 bonds (iShares annual report).
• Trading volume: the number of shares bought and sold on a given day, with the SPDR S&P 500 ETF Trust averaging ~100 million shares per day (SPDR annual report).

Common Misconceptions

Myth: Index funds are only suitable for conservative investors — Fact: Index funds can be used by investors with a wide range of risk tolerance levels, as they offer a diversified portfolio that can be tailored to meet individual investment goals, such as the ~$10 billion in assets held by the iShares Core S&P Total U.S. Stock Market ETF (iShares annual report).

Myth: Index funds are only available for domestic stocks — Fact: Index funds can be used to invest in a wide range of asset classes, including international stocks and bonds, such as the ~$50 billion in assets held by the iShares MSCI EAFE ETF (iShares annual report).

Myth: Index funds are not actively managed — Fact: While index funds do not attempt to beat the market through active buying and selling, the fund manager still plays a crucial role in maintaining the fund's portfolio and tracking the underlying index, with the Vanguard Total Stock Market Index Fund having a team of ~20 portfolio managers (Vanguard annual report).

Myth: Index funds are only available through financial institutions — Fact: Index funds can be purchased directly from the fund manager or through a variety of online brokerages, such as Fidelity or Charles Schwab, with the ~$1 trillion in assets held by the Vanguard Total Stock Market Index Fund (Vanguard annual report).

In Practice

The Vanguard Total Stock Market Index Fund is a concrete example of an index fund in practice, with ~$1 trillion in assets and a dividend yield of 1.8% (Vanguard annual report). The fund tracks the CRSP US Total Market Index, which consists of ~3,000 stocks, and has an expense ratio of 0.04% (Vanguard annual report). In 2020, the fund returned ~20% (Vanguard annual report), closely tracking the performance of the underlying index. The fund's net assets are ~$1 trillion, with ~100 million shares outstanding (Vanguard annual report). By investing in this fund, investors can gain exposure to a broad range of domestic stocks, with the fund's portfolio consisting of ~3,000 stocks, including ~500 large-cap stocks, such as Apple and Microsoft (Vanguard annual report).