What are index funds and how do they work

Index funds are a type of mutual fund or exchange-traded fund (ETF) designed to track the performance of a specific market index, like the S&P 500, Nasdaq Composite, or Dow Jones Industrial Average.

They work by holding all (or a representative sample) of the securities that make up the index they follow. For example, an S&P 500 index fund will invest in the same companies, in the same proportions, as the S&P 500 itself. This strategy is known as passive investing.

Since they don’t rely on frequent trading or active stock picking, index funds tend to have lower fees than actively managed funds. They still have fund managers, however, who rebalance holdings to ensure the fund stays aligned with its benchmark.

Benefits and drawbacks of Index Funds

Benefits of index funds

Some of the benefits of investing in index funds include:

• Lower costs: Because index funds are passively managed, they don’t make frequent trades or require teams of analysts. This means their expense ratios are often much lower than those of actively managed mutual funds.
• Diversification: Index funds give investors instant exposure to hundreds, or even thousands, of companies depending on the index they track. This built-in diversification helps manage risk and smooth out performance over time.
• Transparency: Index funds follow a clearly defined investment strategy and are relatively simple compared to more complex investments. Investors can easily see which assets are held, how the fund is structured, and which index it’s tracking.
• Strong long-term performance: Many index funds have historically outperformed actively managed funds, especially after considering fees. SPIVA data shows that nearly 9 out of 10 active U.S. equity funds have underperformed the S&P 500 over the past 15 years.
• Tax efficiency: Index funds trade relatively infrequently, which means they generate fewer capital gains distributions. This can help investors keep more of their returns after taxes.

Drawbacks of index funds

Potential drawbacks of investing in index funds include:

• Limited flexibility: Index funds are built to match their benchmark, not to respond to market shifts. This means that if the market declines, so will the fund.
• No chance of beating the market: Because index funds are designed to mirror their benchmark, there’s no chance of outperforming them. If you’re looking for above-average returns, index funds might not be for you.
• Exposure to weak or overvalued companies: Because index funds include all companies in an index, they might hold stocks that are overvalued or struggling.
• Concentration risk: Most index funds are weighted by market capitalisation, so larger-cap companies have a bigger impact on performance. These dominant stocks can heavily influence an index fund’s results – which can be both positive or negative.

Types of Index Funds

Index Mutual Funds vs. Index ETFs:

There are two types of index funds: index mutual funds and ETFs. Both follow a passive strategy that aims to track the performance of a market index, however, they differ in terms of structure, pricing, and how they’re traded.

Index mutual funds are purchased directly from the fund provider at the fund’s net asset value (NAV), which is calculated once at the end of each trading day. They’re ideal for long-term investors seeking the simplicity of automatically reinvesting dividends or dollar-cost averaging.

Index ETFs trade on exchanges throughout the day, just like individual stocks. This gives investors the flexibility of employing more trading strategies, like timing their trades, using limit or stop-loss orders, and short selling.

Index fund examples

Index funds can also be divided into categories based on the benchmark they track. Some of the most common include:

• S&P 500 Index Funds: These funds track the S&P 500, made up of 500 of the largest publicly traded companies in the U.S. Examples include the Vanguard 500 Index Fund (VIAX) and SPDR S&P 500 ETF (SPY).
• Nasdaq Index Funds: These funds focus on companies listed on the Nasdaq exchange, which tends to be more tech and growth-oriented. Examples include the Fidelity Nasdaq Composite Index Fund (FNCMX) and Invesco QQQ Trust (QQQ).
• Total Market Index Funds: These funds aim to represent the entire U.S. stock market, including small, mid, and large-cap stocks. Examples are Vanguard Total Stock Market Index Fund (VTSAX) and iShares Core S&P Total U.S. Stock Market ETF (ITOT).

How to invest in Index Funds

If you’re interested in index funds, the good news is that they’re easy to invest in. Below is a step-by-step guideline on how to invest in index funds:

1. Choose an investment platform

Start by choosing an online brokerage or investment platform. Look for providers that offer low trading fees, user-friendly interfaces, good customer support, research and analytical tools, and access to a wide range of index funds.

2. Open and fund your account

Once you’ve chosen a platform, it’s time to open an account. This might involve filling out basic personal and financial information, setting your investment preferences, and transferring money from your bank account.

3. Pick an index

Next, you can decide which part of the market you want to track. Popular indexes are the S&P 500, Nasdaq Composite, Russell 2000, and MSCI EAFE.

4. Choose an index fund

Once you’ve chosen an index, you can research and compare funds that track it. This is also the time to decide between an index mutual fund or an ETF. Key things to consider when choosing a fund include:

• Expense ratios: Lower is generally better, since it can impact long-term returns
• Fund structure: To recap, ETFs are more flexible and can be used for trading strategies, while mutual funds are more suited for automated investing and dollar-cost averaging
• Minimum investment: Some index mutual funds require a minimum investment, while ETFs generally don’t
• Performance history: Check that your fund’s performance has closely matched its benchmark’s returns.

5. Buy shares

Now that you’ve chosen a fund, you’re ready to invest! You can buy ETFs throughout the trading day, but if you’re investing in a mutual fund you’ll need to purchase it at the end-of-day NAV.

6. Monitor your portfolio

Even though index funds are designed for long-term investing, it’s important to check in periodically to make sure your holdings still align with your goals, risk tolerance, and time horizon.

Best Index Funds to invest in

There are hundreds of index funds out there, and it can be difficult to know where to start. To help you on your journey, we’ve listed some of the best low-cost index funds you can buy.

Cost of investing in Index Funds

The primary cost to watch out for with index funds is the expense ratio, which is a small percentage deducted from your investment each year to cover operations.

Generally, expense ratios below 0.10% are considered good – many of the top-performing index funds we’ve listed above charge as little as 0.02% to 0.04%.

Index funds vs. stocks

Both stocks and index funds are good investment options, but the right one really comes down to your investment objectives, risk tolerance, and how much time you want to dedicate towards investing.

With individual stocks, you’ll have to spend time researching, choosing, and buying shares of specific companies. You may earn higher returns this way, but you’re also taking on more risk since a single company’s poor performance can affect your investment significantly.

With index funds, however, you have built-in diversification that can reduce the impact of any single company’s performance on your overall returns. You can also sit back and let someone else handle the portfolio management for you.

Are index funds safer than stocks?

Generally, yes. Index funds spread your investment across multiple companies, which reduces the risk of large losses tied to one stock. That said, index fund investing involves risk, just like any other investment.

Do index funds or stocks offer higher returns?

Individual stocks can outperform the market, but they can also underperform or fail entirely. Index funds tend to deliver more steady returns that reflect the market’s overall performance.

Example of an Index Fund

The Vanguard S&P 500 ETF (VOO) is one of the most popular index funds. It holds all 500 companies included in the S&P 500, weighted by market capitalisation, meaning larger companies – like Apple, Microsoft, Amazon, and Nvidia, carry more weight in the fund.

VOO spans multiple sectors, but its largest asset allocations are in information technology, healthcare, and financials. Since its inception in 2010, VOO has closely mirrored the performance of the S&P 500. As of 2025:

• 10-year average annual return: ~13.2%
• 5-year average annual return: ~18.8%
• 2024 return: ~24.98%.

The fund has a low expense ratio of 0.03%, which means it deducts $0.30 per year for every $1,000 invested.

Disclaimer: FOREX.com Australia is a Contracts for Difference (CFD) issuer and our products are traded off exchange. We do not offer direct ownership of the product and exposure to index funds is available solely via Contracts for Difference (CFDs). This material relates to the underlying asset and does not constitute a recommendation or offer to trade.