Investing in Index Funds: What Every Investor Should Know

A Beginner's Guide to Smart Investing with Index Funds

Part of the Series Guide to Index Fund Investing What Are Index Funds, and How Do They Work? Introduction to Index Funds

1. Index Fund
2. Investing in Index Funds CURRENT ARTICLE
3. Is it Possible to Invest in an Index?
4. The Lowdown on Index Funds
5. Tracker Fund

Index Fund Examples

1. How Can I Buy an S&P 500 Fund?
2. Top S&P 500 Index Funds
3. Put $10,000 in the S&P 500 ETF and Wait 20 Years
4. How Vanguard Index Funds Work
5. Vanguard Total Stock Index vs. Vanguard 500 Index Funds
6. The 4 Best Total Market Index Funds
7. Top Small Cap U.S. Index Funds

Index Fund Risks and Considerations

1. Index Mutual Funds vs. Index ETFs
2. 5 Things You Need to Know About Index Funds
3. 5 Reasons to Avoid Index Funds
4. Can an Index Fund Investor Lose Everything?
5. What Is Considered a Good Expense Ratio?
6. The Hidden Differences Between Index Funds

For investors seeking a proven approach to building long-term wealth, index funds have become the cornerstone strategy for both retail and major institutional investors.

“One of the most significant headwinds to profitable investing is management fees. By taking a passive, index-based investment approach, an investor can keep fees low while diversifying the portfolio across industries, sectors, and geographies,” said David Tenerelli, a certified financial planner at Values Added in Plano, Texas. “This results in the investor being able to benefit from broad economic growth regardless of the fortunes of individual companies.”

This guide explores what you need to know about index funds, from their fundamental principles to practical implementation strategies.

Key Takeaways

• Index funds replicate the performance of a specific index, offering a passive investment strategy.
• They are lower in cost due to lower management fees and taxes than actively managed funds.
• Index funds offer broad diversification across several sectors and asset classes, reducing overall investment risk.
• Potential drawbacks include a lack of flexibility and limited upside potential during some periods.

What Is an Index Fund?

An index fund is an investment vehicle, usually a mutual or exchange-traded fund (ETF), that tracks the performance of a specific market index, such as the S&P 500 Index or the Dow Jones Industrial Average. Unlike actively managed funds, where portfolio managers make specific investment decisions to buy or sell certain assets, index funds employ a passive investment strategy to simply mirror the holdings and performance of their target index.

When you invest in an S&P 500 index fund, therefore, you’re essentially buying small portions of all 500 companies included in that index. This means your investment is diversified across hundreds of companies with each share.

Index investing emerged in the 1970s when John Bogle, founder of Vanguard, introduced the first index mutual fund for individual investors. At its launch in 1976, the Vanguard 500 Index Fund was initially met with skepticism and dubbed “Bogle’s Folly.” However, the fundamental idea behind index investing–that most active managers fail to outperform the market after accounting for fees–has proven durable.

From humble beginnings of just around $10 million in assets, U.S. index funds have grown to command more than $16 trillion as of year-end 2024, representing a fundamental shift in how both institutional and individual investors approach the market.

Types of Index Funds

Index funds track different indexes or market segments:

Broad Market Index Funds

These funds track comprehensive market indexes like the total U.S. stock market or global stock market. They provide very wide diversification and are often recommended as core portfolio holdings.

Examples include the following:

• iShares Russell 3000 ETF (IWV)
• Vanguard Total World Stock ETF (VT)
• Fidelity ZERO Total Market Index Fund (FZROX)

Large-Cap Index Funds

These funds track major indexes like the S&P 500 and offer exposure to America's biggest corporations.

Examples include the following:

• SPDR S&P 500 Index ETF (SPY)
• Vanguard Mega Cap ETF (MGC)
• Fidelity 500 Index Fund (FXAIX)

International Index Funds

These funds track non-U.S. markets, allowing investors to gain global exposure. They might track developed markets, emerging markets, or both, offering geographical diversification.

Examples include the following:

• iShares Core MSCI EAFE ETF (IEFA)
• Vanguard FTSE Emerging Markets ETF (VWO)
• Fidelity International Index Fund (FSPSX)

Tip

In addition to broad international funds, there are also many ETFs that track single-country foreign indexes.

Sector-Specific Funds

These specialized funds track specific industry sectors, such as technology, healthcare, or real estate.

Examples include the following:

• Technology Select Sector SPDR (XLK)
• Vanguard Health Care ETF (VHT)
• Vanguard Real Estate Index Admiral Fund (VGSLX)

Important

Sector funds are typically used to complement core holdings rather than as primary positions.

Fixed Income/Bond Index Funds

Rather than tracking an equity index, fixed-income index funds and ETFs track bond market indexes.

Most broad bond market indexes, like the Bloomberg U.S. Aggregate Bond Index, focus on investment-grade securities, including a mix of government bonds, corporate bonds, and mortgage-backed securities.

Examples include the following:

• iShares Core U.S. Aggregate Bond ETF (AGG)
• Vanguard Total Bond Market ETF (BND)
• Fidelity U.S. Bond Index Fund (FXNAX)

Important

Bond index funds often have slightly higher tracking error than equity funds due to the complexity of the bond market and difficulty in perfectly replicating bond indexes.

The Advantages and Disadvantages of Index Funds

Pros

• Very low fees

• Lower tax exposure

• Passive management tends to outperform over time

• Broad diversification

Cons

• No downside protection

• Cannot take advantage of opportunities

• Lack of flexibility

• Lack of professional portfolio management

Advantages

Cost

One of the most compelling advantages of index funds is their comparatively low cost. Since they don’t require teams of analysts and portfolio managers to select investments, they typically charge much lower fees than actively managed funds. While an actively managed fund might charge an expense ratio of 1% or more, many index funds charge less than 0.15%. This difference in fees can translate to significantly higher returns over long periods.

Tip

On a $100,000 investment over 30 years, assuming an 8% annual return, the difference between a 0.10% and 1.00% expense ratio amounts to over $220,000 in saved fees.

Tax Efficiency

Because index funds typically have low turnover (they only buy and sell securities when the index composition changes), they have fewer taxable events. This characteristic can result in lower capital gains distributions.

Broad Diversification

Index funds inherently provide broad diversification across many securities. Diversification helps protect against the risk of any single holding's poor performance bringing down your portfolio.

Transparency

Investors always know exactly what they own since the fund simply tracks a published index. This clarity contrasts with actively managed funds, where holdings may change based on the manager's decisions.

Disadvantages

Market Dependency

Index funds are designed to match market performance, not beat it. During market downturns, these funds will naturally decline along with their underlying index. And unlike actively managed funds, index fund managers can’t take defensive positions or hedge during periods of market turbulence.

Limited Flexibility

The passive nature of index funds means they must hold securities in proportion to their index weightings, regardless of the individual merits of specific companies. This inflexibility can sometimes result in overexposure to overvalued sectors or companies.

For example, in 2025, the so-called magnificent seven tech companies—Apple Inc. (AAPL), Amazon.com Inc. (AMZN), Alphabet Inc. (GOOGL), Meta Platforms, Inc. (META), Microsoft Corporation (MSFT), NVIDIA Corp. (NVDA), and Tesla, Inc. (TSLA)— make up almost a third of the index, meaning any downturn in that sector would be a problem for investors in S&P 500 index funds.

How To Invest in Index Funds

Step 1: Choose a Brokerage Account

The first step is opening a brokerage account if you don't already have one. Major brokers all offer a wide selection of index funds, often with no commission fees for trades.

Step 2: Determine Your Investment Goals

Before selecting specific index funds, set out your investment objectives, time horizon, and risk tolerance.

Step 3: Select Your Index Funds

When choosing specific index funds that fit your goals, consider these key factors:

• Expense ratio: Look for funds with the lowest possible expense ratios while still tracking your desired index effectively.
• Tracking error: Compare how closely the fund has historically tracked its target index.
• Assets covered: Ensure your chosen funds provide exposure to your desired market segments.
• Trading volume: Higher trading volume typically means better liquidity and tighter bid-ask spreads—meaning you can trade them quickly at a lower cost.
• Assets under management (AUM): While not always a red flag, funds with small AUM may have a higher risk of closure or comparatively higher costs because they haven’t achieved efficiency of scale.

Step 4: Implement Your Strategy and Stick with It

The most important part of an indexing strategy is to continue to hold it for the long term, even through bear markets or unfavorable conditions. Consider implementing a dollar-cost averaging strategy by investing fixed amounts at regular intervals. This approach can help cut the impact of market volatility on your investment returns.

"It takes discipline to continue to buy investments during a market downturn," Tenerelli said. "But a shift in mindset can help—rather than fearing financial loss, an investor can reframe as buying stocks 'on sale.'"

The chart below shows the results of using dollar-cost averaging by putting $50 aside each month in an S&P 500 index fund for 20 years.

The Bottom Line

Index funds offer a compelling investment option for both novice and experienced investors. Their combination of low costs, broad diversification, and simplicity makes them an excellent foundation for long-term investment success.

While they may not offer the excitement of picking individual stocks or the potential for market-beating returns, index funds have proven a reliable path to building wealth over time.