Written by: Ryan (he/him)
2 min read | Published: January 4, 2024
What are index funds and how do they work?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that is comprised of a portfolio that mimics the components of a financial market index. They can be a great investment if you’re planning to save for the future because these are slow-growing, long-term investments that typically offer more financial stability. For this reason, index funds are generally associated with retirement accounts including individual retirement accounts (IRAs) and 401(k)s. For almost every financial market, there is an index and index fund available. The easiest way to understand index funds is to think of them as a collection of stocks that imitate a market fund.
There are many market indexes in the United States that index funds mimic, including:
One way an index fund could mimic a market index is by comparing the number of stocks it contains. For example, the S&P 500 is made up of 500 stocks, so an index fund could own a proportionate number of stocks. However, the Dow Jones is made up of only 30 stocks, so an index fund would similarly own fewer stocks.
How to invest: When investing in index funds, there are usually fewer fees associated than with actively managed mutual funds. In contrast to mutual funds, you aren’t relying on someone to study market trends, read over financial statements, and make the call to buy. Instead, you’re purchasing an investment that will be managed by a company according to specific criteria that mimics a market index, so less strategy is required. Investing in index funds can range from as little as a dollar to thousands of dollars, but once you have made your initial investment, you can add smaller amounts of money to them. The biggest cost of an index fund investment is its expense ratio. Expense ratios are fees that are associated with shareholders’ overall investment resulting in a percentage of it being taken out. The expense ratio fee can be found within the mutual fund’s prospectus or when you look up a mutual fund using a financial website. Taxes will also play a role in the return on investment when considering trading for capital gains outside of retirement accounts such as a Roth IRA or 401(k).
Index funds may be a great way to diversify your portfolio with a variety of companies representing small, medium, or large capital values. Being able to invest in multiple companies rather than just one can allow for some security during times of economic downturn. Index funds can be a strong consideration when long-term financial goals such as retirement are a priority for the investor.
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