Index Funds: What They Are and How They Work

An index fund is an investment fund designed to follow or broadly reflect the performance of a particular market index or other defined benchmark. Instead of relying primarily on frequent investment selection, an index fund generally follows a stated methodology.

What Is an Index Fund?

A market index is a measurement designed to represent the performance of a selected group of investments or a particular market segment. An index fund aims to provide exposure based on a chosen index or benchmark.

The exact method used to follow an index can vary. Some funds may hold all or most of the securities represented by the index, while others may use a different approach intended to achieve similar overall exposure.

How Do Index Funds Work?

An index fund follows rules based on the index it is designed to track. Those rules may determine which investments are included and how much of the fund is allocated to each holding.

When the underlying index changes its composition or methodology, the fund may also make changes in accordance with its own stated investment approach.

Potential Benefits of Index Funds

Depending on the fund and the index it follows, index funds may offer broad exposure to a particular market or investment category.

Potential characteristics may include:

• Exposure to multiple investments through a single fund.
• A rules-based investment approach.
• Potential diversification depending on the underlying index.
• Clear information about the benchmark or methodology being followed.
• Potentially different cost structures compared with other investment approaches.

Index Funds and Diversification

An index fund may hold exposure to many securities, but the level of diversification depends on the index being tracked. A narrowly focused index may still involve significant concentration in a particular sector, country or type of investment.

Holding an index fund does not guarantee complete diversification across every possible investment risk.

Tracking Difference

An index fund may not produce exactly the same return as the index it follows. Differences can occur because of fees, expenses, transaction costs, cash holdings, taxes and other operational factors.

This difference between the fund's performance and the benchmark can be an important consideration when evaluating an index-tracking investment.

Investment Risks

Index funds can lose value. If the investments represented by the underlying index decline, the value of the fund may also decline.

An index fund is not automatically low risk simply because it holds multiple investments. Risk depends on the underlying assets, market conditions and the concentration of the index.

Costs and Expenses

Funds may charge management fees and may incur other expenses. These costs can affect investment returns over time.

Investors may consider reviewing the fund's documents to understand its fees, investment objective, benchmark and other relevant information.

Questions to Consider

• What index or benchmark does the fund aim to track?
• How broad or concentrated is the underlying index?
• What types of investments are included?
• What fees and expenses apply?
• What investment risks are involved?
• How does the fund fit within the overall portfolio?
• Does the investment time horizon match the investor's financial goals?

Key Takeaways

• An index fund is generally designed to follow a defined market index or benchmark.
• The fund's holdings and methodology depend on the index and investment strategy.
• Index funds can provide exposure to multiple investments through a single fund.
• Diversification depends on the underlying index and is not guaranteed to eliminate risk.
• Fees, expenses and tracking differences can affect returns.
• Index funds can lose value and do not guarantee positive investment outcomes.