If you’ve heard that index funds are the best way to invest but aren’t quite sure what they are or how they work, this guide covers everything you need to know — in plain language.

What is an index fund?

An index fund is a type of investment fund that tracks a specific market index — a predefined list of stocks or bonds. Rather than having a fund manager pick individual investments, an index fund simply holds everything in a particular index in the same proportions.

The most famous example: the S&P 500 index fund holds shares in the 500 largest US public companies, proportionally weighted by market capitalisation. When you buy one share of an S&P 500 index fund, you’re instantly invested in Apple, Microsoft, Amazon, Google, and 496 other companies.

How index funds work

A market index is maintained by a third party (like S&P, MSCI, or FTSE). It defines its membership rules — which companies qualify and how they’re weighted. An index fund simply follows those rules.

When a company is added to or removed from an index, the fund buys or sells accordingly. This is largely automated, which is why index funds are called “passively managed” — the fund manager isn’t making active decisions about which stocks to buy.

Index fund vs. ETF: what’s the difference?

An ETF (Exchange-Traded Fund) is a structure, not a strategy. ETFs can be index funds (most are), but they can also track anything — currencies, commodities, even volatility.

The distinction:

  • Index fund: a strategy of tracking an index, can be structured as a mutual fund or ETF
  • ETF: a fund that trades on a stock exchange like a share, priced throughout the day
  • Index ETF: an ETF that passively tracks an index (e.g., VTI, SPY, IVV)

For practical purposes, index mutual funds and index ETFs are very similar. The ETF version is often slightly more tax-efficient and is available with lower minimums. Many people use these terms interchangeably.

Why index funds beat most active funds

This is the most important fact in retail investing, backed by decades of data:

Most actively managed funds underperform their benchmark index after fees, over long time periods.

The S&P Dow Jones SPIVA report consistently shows that over 15-year periods, approximately 88-92% of actively managed large-cap funds underperform the S&P 500.

Why? Two reasons:

  1. Markets are broadly efficient. Millions of sophisticated investors analyse the same information, making it very hard to consistently find mispriced stocks.
  2. Fees compound against you. A 1% annual fee might sound small, but it reduces a 30-year portfolio by roughly 25% compared to a 0.03% fee fund.

This is the “cost hypothesis” — the more investors pay in fees, the less they keep. Passive index investors capture nearly the full market return.

FundWhat it tracksExpense ratio
VTI (Vanguard)Total US stock market0.03%
VXUS (Vanguard)Total international (ex-US)0.07%
BND (Vanguard)US bond market0.03%
FSKAX (Fidelity)Total US market0.015%
FZROX (Fidelity)US total market0% (Fidelity zero-fee)
SPY (State Street)S&P 5000.0945%

How to buy an index fund

  1. Open a brokerage account — Fidelity, Vanguard, Charles Schwab, and most others are free. If you have a 401(k), index fund options are typically already available.
  2. Choose your fund — start with a broad US total market or S&P 500 fund.
  3. Buy shares — you can start with as little as $1 using fractional shares at many brokers. Vanguard mutual fund minimums start at $1,000.
  4. Automate contributions — set up regular investments (monthly or with each paycheck) to take advantage of dollar cost averaging.
  5. Leave it alone — the biggest mistake is selling during downturns. Index investing rewards patience.

The simplest possible portfolio

For most people, two funds cover nearly everything:

  • 80-90% in a total world stock fund (e.g., VT — Vanguard Total World)
  • 10-20% in a bond fund (e.g., BND)

Or for even more simplicity: a single target-date fund that automatically adjusts as you approach retirement.

Related tools: