What is an index fund?

An index fund is a collection of stocks, bonds, or other securities that tracks a market index -- a group of securities that's used to represent a segment of the market. A stock index fund, for example, owns shares of the component stocks that make up the index that it tracks, and fund investors own a proportional stake in all of those stocks.

There are thousands of index funds, and they vary greatly according to the indexes they track. Index funds are available for a wide range of investments beyond stocks, including bonds, commodities, and real estate investments. Some stock index funds own just a small number of stocks, while others own thousands of different stocks. Regardless of which index they track, the primary objective of an index fund is to match the performance of the underlying index.

READ MORE: What Is a Stock Market Index?

How do index funds work?

Index funds have fund managers whose job it is to ensure that the fund tracks its underlying index. Because an outside third party index provider creates and maintains the index itself, the job of the fund manager is relatively simple: buy the investments that the index provider puts in the index, and then make further purchases or sales when the index provider makes subsequent changes to the index.

Index funds can be structured in two primary ways. Index mutual funds are offered directly through mutual fund companies, and many brokers also offer access to certain index mutual funds in their brokerage accounts. Index exchange-traded funds trade directly on stock exchanges, allowing anyone with a brokerage account to buy or sell shares at any point when the stock market is open for trading.

READ MORE: Mutual Funds vs. ETFs: Which Is Better for You?

What are the advantages of investing in index funds?

Index funds can help you save the time and effort of researching individual investments and managing a portfolio yourself. Rather than having to choose individual stocks or bonds, a single index fund can instantly give you a well-diversified set of investments. Plus, index funds are available to all investors, even those who have only modest amounts to invest, which increases investing access for many.

Moreover, investing in index funds removes the psychological biases that individual investors must overcome to manage a portfolio effectively. Some of those biases include the following:

  • Loss aversion: The fear of losing money causes investors to sell at sub-optimal times and invest in lower risk equities, which end up producing lower returns.
  • Narrow framing: Making investment decisions without considering the context of a total portfolio.
  • Mental accounting: Taking undue risk in one area while avoiding rational risk in another due to mentally separating money into different buckets.
  • Anchoring: Focusing on the past instead of adapting to a changing market.
  • Unrealized lack of diversification: Thinking a portfolio is diversified despite investing in highly correlated assets.
  • Irrational optimism: Believing good things will happen to you and bad things will happen to others.
  • Herding: Copying the behavior of others, which usually results in buying high and selling low.
  • Regret: Letting previous errors get in the way of making new decisions.

The ease of buying and holding an index fund and the confidence that the index fund will match the index's return can help control loss aversion and other psychological biases that hurt the returns of individual investors who actively manage their own portfolios.

A bull and a bear figurine on top of paper stock charts.

Image source: Getty Images.

How are index funds better than other types of funds?

One huge advantage that index funds have over other types of funds is cost. An index fund manager's job is simply to match the index the fund tracks, which takes significantly less time and effort than the analysis and portfolio management involved with actively managed funds. Index funds are therefore able to operate much more cheaply than typical actively managed funds. A few index funds have even started offering shares with no expenses at all. With some actively managed fund carrying an annual expense ratio of 1% or more, paying an index fund's expense ratio of 0.1% or less can save you a lot of money over time.

In addition, index funds are more tax-efficient than most actively managed funds. Any time a fund manager sells a holding, there are tax implications for everyone who owns shares of the fund. Because many index providers don't make huge changes to their indexes on a frequent basis, index funds often don't buy and sell investments as much. Index fund managers still have to invest new money as it comes in, but the fund can be selective about selling stocks when necessary in a way that minimizes capital gains taxes. By contrast, actively managed mutual funds buy and sell positions all the time, and investors don't have complete control over the resulting taxable gains.

What are some examples of index funds?

Two index funds stand out as pioneers of the investing world, and both track the popular S&P 500 index. The Vanguard 500 Index Fund (NasdaqMUTFUND: VFINX) is credited as the first ever index mutual fund, started by Vanguard founder Jack Bogle in 1976. Bogle wanted to give investors a way to invest passively rather than rely on mutual fund managers making buy and sell decisions in an effort to outperform the market. His research for his senior thesis at Princeton led him to conclude actively managed mutual funds "may make no claim to superiority over the market averages." In fact, actively managed funds often underperform market averages due to high fees and expenses. Vanguard has become a giant in the index fund industry, with dozens of index funds.

Later, the SPDR S&P 500 ETF (NYSEMKT: SPY) was the key first mover in the index ETF realm. First traded in the early 1990s, the SPDR S&P 500 ETF let investors trade shares of the fund throughout the trading day, offering what many saw as an advantage over the once-daily trading that mutual funds allow. The company that manages that SPDR line of ETFs has also seen huge growth in both the number of index funds it offers and the total assets it has under management.

READ MORE: What Is the S&P 500?

Nowadays, you can find an index fund to track just about any index you can think of. There are index funds for popular U.S. stock benchmarks like the Dow Jones Industrial Average and Nasdaq Composite, but there are also funds that track smaller subsets of the stock universe. Demand for index funds has created a cottage industry among index providers to come up with increasingly focused indexes for funds to track.

One hand giving lots of money to another.

Image source: Getty Images

What are the disadvantages of investing with index funds?

Some investors are happy using solely index funds for their entire portfolio. However, there are some limitations of index funds that you should consider before you commit to building an investment plan entirely around them.

The biggest disadvantage of index funds is that you're relinquishing control over how your money gets invested. Your investments in an index fund are made at the whims of the index rule makers. Even if you dislike a company and don't want to own its stock, you won't have a choice if it's in an index you otherwise like, or if the company becomes part of that index in the future. Likewise, you might find an index is perfect, except that it's missing some stocks that you'd really like to own. You can always buy those stocks separately, but that requires extra work beyond simply investing in the index fund.

Investing in index funds also removes your ability to react to the market. As discussed above, that can be an advantage for many investors who face serious psychological biases when it comes to buying and selling stocks and other investments. But if you see an opportunity presenting itself in the market or you feel a company has become overvalued, you can't easily make an investing decision based on that information if you're committed to index funds.

If you like researching individual equities, then you might prefer managing your own portfolio of just a handful of stocks rather than buying an index fund. You don't really need exposure to 500 or more stocks to have a diversified portfolio. All it takes is choosing a dozen or two companies you think have the best chance of producing long-term returns that outperform the overall market.

If you're really not interested in all that investment research and just want to grow your money, though, index funds provide a great solution.

Get wealthier with index funds

Investing in index funds is one of the simplest ways to grow your wealth over time. For someone that's not interested in researching individual companies to put together a balanced and diversified portfolio themselves -- or for those that are simply afraid they'll fall prey to the psychological biases that prevent individual investors from doing well in the market -- index funds are the best investment tool available.