Quick answer
An index fund is a mutual fund or ETF that seeks to track the returns of a market index by holding the index's securities. It usually trades less than an actively managed fund, which can keep costs lower — but it falls when the index falls [1].
Key points
- An index fund copies a market index instead of trying to beat it.
- You cannot invest in an index directly; an index fund is the indirect route.
- Many indexes weight companies by market capitalization, so the largest firms count the most.
- Fees, trading costs and sampling mean a fund's return will differ slightly from its index.
- Not every index fund is low-cost, and an index fund does not try to avoid market declines.
#What is an index fund?
Start with the index. A market index "measures the performance of a 'basket' of securities," meant to represent a sector of a stock market or of an economy, according to the SEC's investor bulletin [1]. The same bulletin points out that you cannot invest directly in an index. An index fund is the workaround: a mutual fund or ETF that seeks to track the returns of a market index [1]. See what a stock market index is for the basics of how indexes are built.
The SEC's guide adds that index funds generally invest primarily in the component securities of the index and typically have lower management fees than actively managed funds [2]. An index fund can be structured as a mutual fund or as an ETF; the indexing idea is the same.
#How is passive investing different from active investing?
Index funds have generally followed a passive style, which the SEC describes as aiming to maximize returns over the long run "by not buying and selling securities very often" [1]. An actively managed fund, by contrast, "often seeks to outperform a market" by doing more frequent purchases and sales [1].
| Index (passive) fund | Actively managed fund | |
|---|---|---|
| Goal | Match the return of a chosen index | Beat a market benchmark |
| Who picks holdings | The index rules | A portfolio manager or team |
| How often it trades | Generally less often | Often more frequently |
| Costs | Often lower — but not always | Often higher management fees |
| During a market drop | Follows the index down | Manager may try to react, with no assurance of success |
#How does index weighting decide what you own?
An index is a recipe with rules for which securities are in it and how much each counts. The SEC notes that many indexes use market capitalization — a company's share price times its shares outstanding — to set weights, so companies with a higher market capitalization account for a greater share of the index [1]. Our glossary explains market capitalization in more detail.
Worked example
A three-company index, weighted by size
Imagine a tiny index of three companies with market capitalizations of $600 billion (A), $300 billion (B) and $100 billion (C). You put $1,000 into a fund that tracks it.
- Total market cap ($600B + $300B + $100B)
- $1,000 billion
- Company A weight ($600B ÷ $1,000B) → your dollars
- 60% → $600
- Company B weight ($300B ÷ $1,000B) → your dollars
- 30% → $300
- Company C weight ($100B ÷ $1,000B) → your dollars
- 10% → $100
In a market-cap-weighted fund, the biggest company drives the most of your result. If A falls 10%, your fund falls about 6% from A alone.
Hypothetical index; weights and dollar amounts calculated in Python. Real broad indexes hold hundreds or thousands of securities.
Where $1,000 goes in a cap-weighted index fund
#Why does an index fund not match its index exactly?
Because a real fund has real costs, and an index does not. The SEC bulletin says an index fund may underperform its index because of fees and expenses, trading costs and tracking error [1]. A fund may also invest in only a sampling of the securities in the index rather than all of them [1]. The gap between fund and index return is often called tracking difference; how much it varies over time is tracking error.
Worked example
Same index, two expense ratios
An index returns 8% in a year. Two hypothetical funds track it perfectly before costs: one charges 0.10% a year, the other 0.75%. Each holds $10,000 at the start.
- Index: $10,000 × 1.08
- $10,800.00
- Fund with 0.10% expenses: $10,800 × (1 − 0.0010)
- $10,789.20
- Fund with 0.75% expenses: $10,800 × (1 − 0.0075)
- $10,719.00
Both funds hold the same index, yet the cheaper one ends the year $70.20 ahead. Over many years, that gap compounds.
Hypothetical returns calculated in Python, with costs taken once at year end for simplicity. See expense ratios and fund fees for a long-run view.
#What are the risks of index funds?
An index fund carries the risk of the index it follows. If the index drops 20%, a fund tracking it drops about the same. The SEC warns that an index fund "may have less flexibility than a non-index fund to react to price declines" in the securities in the index [1]. It will not move to cash because a manager expects trouble.
Not all index funds are broad. Some track a single sector, country or theme, which concentrates risk. And the SEC reminds investors that "not all index funds have lower costs than actively managed funds" [1]. Read the fund's fee table and the description of the index before investing. Spreading money across many holdings is the idea behind diversification, but diversification does not prevent losses.
Common beginner mistakes
Thinking "index" means "cheap"
Many index funds have low expense ratios, but some charge much more. Check the number rather than the label.
Assuming an index fund cannot lose money
It falls with its index. Broad diversification spreads company-specific risk; it does not remove market risk.
Owning three funds that track the same companies
Different fund names can hold nearly identical stocks. Look at the index each one follows before calling a portfolio diversified.
Ignoring how the index is weighted
In a cap-weighted index, a handful of very large companies can dominate. Know what share of your money sits in the top holdings.
What's the bottom line?
An index fund trades the hope of beating the market for the simpler goal of matching it, minus costs. You get the index's breadth, its weighting and its downturns. Before choosing one, check which index it follows, how that index is weighted and what the fund charges. Then see how the cost side plays out over decades in expense ratios and fund fees.
Frequently asked questions
Is the S&P 500 an index fund?
No. The S&P 500 is an index — a list and a measurement. Many mutual funds and ETFs track it, and those are index funds. Read our profile of the S&P 500.
Are index funds mutual funds or ETFs?
Either. The SEC defines an index fund as a mutual fund or ETF that seeks to track a market index. The tracking idea is the same; the trading mechanics differ.
Do index funds beat actively managed funds?
Not always, and past results do not predict future ones. Index funds aim to match their index minus costs; active funds try to beat a benchmark and may or may not succeed after their own costs.
What is tracking error?
It describes how much an index fund's return varies from its index's return over time. Fees, trading costs and holding only a sample of the index all contribute.
Sources
Grade A = primary source (regulator, government agency, official rulebook or the index provider's own documents). Numbers in brackets in the text point here.
- U.S. SEC — Investor.gov. Investor Bulletin: Index Funds (2018). Accessed 2026-10-03.A
- U.S. Securities and Exchange Commission. Mutual Funds and ETFs: A Guide for Investors (2016). Accessed 2026-10-03.A
- S&P Dow Jones Indices. S&P 500 (2026). Accessed 2026-10-03.A
This page is general education, not personal financial, tax or legal advice. Figures in worked examples are hypothetical and calculated before taxes and fees unless stated. Rules and limits change; check the linked primary sources for the current version. How we check every page.
