What is an index fund and how does it work?

You can trade stocks in many ways, such as buying and selling shares directly on exchanges, trading indices via CFDs, and investing in ETFs and index funds. Don’t know what an index fund is? This comprehensive guide tells you all about them so that you can make an informed decision.

What is an index fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) that tracks the performance of a specific stock index, like the US 500 or the US Wall Street 30. Unlike actively managed funds, where fund managers constantly buy and sell securities with the aim of outperforming the market, index funds try to mimic the performance of the stock index they follow.

So, the basic difference between actively managed funds and index funds is in how they are managed. Actively managed funds involve extensive research, analysis and frequent trading by professional managers who hope to beat the market. This often comes with higher management fees. Index funds, on the other hand, are passive instruments that do not try to time the market.

How do index funds work?

As mentioned above, an index fund’s portfolio is structured to mirror a specific stock index. For example, since the information technology sector accounts for 31.6% of the stocks on the US 500 as of 2025, an S&P index fund will also give roughly 31% of its allocation to IT stocks.

So, what is the role of fund managers in index funds? Well, their primary task is to ensure the fund’s holdings accurately reflect the chosen index. This involves periodically rebalancing the fund to mirror changes in the index, such as when a company is added or removed, or when the weighting changes. This reduces the need for costly research and frequent trading, leading to lower fees for investors.

The three big index funds explained

While there are countless market indices worldwide, a few stand out as benchmarks for global economic health and investment performance.

S&P 500 index fund

Perhaps the most widely recognised stock index globally, the US500 tracks the performance of 500 of the largest stocks listed on US stock exchanges. The S&P 500 index fund offers investors diversified exposure to a large portion of the US stock market, representing roughly 80% of its total market cap.

DJIA index fund

The US Wall Street 30 is a price-weighted index that includes 30 blue chip US stocks. While it is less broad than the US500, the US30 is a closely watched indicator of the health of major industrial sectors in the US.

Nasdaq 100 index fund

The US Tech 100 includes 100 of the largest non-financial companies listed on the Nasdaq stock exchange. This index is heavily weighted towards technology and growth-oriented stocks, offering investors exposure to these dynamic sectors.

Interested in diversifying your portfolio with indices? Learn more about index trading and how it works.

ETF vs index fund: key differences

While many index funds are structured as ETFs, it’s important to understand that not all ETFs are index funds, or vice versa. Here’s a breakdown of ETFs vs index funds:

Cost differences and management fees

Both funds usually charge lower fees than actively managed mutual funds. However, while index funds might have a minimum investment requirement, ETFs can even be bought for the price of a single share. ETFs generally have slightly lower expense ratios than their mutual fund counterparts due to their simpler structure.

Liquidity and tradability

ETFs are traded like stocks on an exchange. So, their prices fluctuate continuously, and they can be bought and sold at any time during market hours. Index funds, on the other hand, are priced only once a day, at market close. They can only be bought or sold at that price. This makes ETFs highly liquid and some traders use them for day trading or active portfolio adjustments. Mutual funds are better suited for buy-and-hold strategies.

Benefits of investing in index funds

Traders may consider index funds to offer numerous advantages. Of these, perhaps the most meaningful is their lower fees compared to actively managed funds. Since index funds don’t need extensive research teams or frequent trading, their operating costs are much lower. Over time, these lower fees can considerably impact overall returns.

Index funds can often be a popular choice for portfolio diversification and risk management. For example, an S&P 500 index fund gives you exposure to 11 different sectors of the US economy. Plus, historically, many actively managed funds fail to consistently beat their benchmark index after fees. Index funds, by design, roughly match the returns of the index they follow, offering a simple yet powerful way to capture market growth.

Drawbacks and risks of index funds

Like all other trading instruments, index funds also have some limitations. During market downturns, an index fund tends to decline along with the overall market. However, the managers of an actively managed fund might try to mitigate losses by moving to cash or defensive stocks. The passive approach means index funds cannot capitalise on specific opportunities or avoid underperforming sectors.

It is important to learn more about risk management before investing your money in the live markets.

Real-world examples of index fund investing

Index funds are popular among both institutional and retail investors. Large pension funds, endowments and sovereign wealth funds often allocate significant portions of their portfolios to index funds. This allows them to gain broad market exposure, manage costs and establish a baseline for their overall portfolio performance. Institutional investors might use index funds as core holdings, freeing up resources for more targeted active strategies.

For retail investors, index funds offer a means of passive investing. They are a simple, low-cost way to build a diversified portfolio without needing extensive market knowledge or constant market monitoring.

Performance of index funds during market crashes and recoveries

During major market crashes, such as the 2008 financial crisis or the COVID-19 pandemic downturn in 2020, index funds experienced significant declines, mirroring the broader market. Then came 2024, when the stock markets had a dream run, with the US 100 gaining 28.64%, the US 500 up 23.31% and the US30 adding 12.88%. Index funds replicating the performance of these indices also experienced similar outperformance.

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FAQs

What is an index fund and how does it work?

An index fund aims to replicate the performance of a specific market index by holding all the securities in that index in similar proportions. It works by passively tracking the index, rather than actively buying and selling stocks.

What is the difference between an index fund and an ETF?

An index fund can be structured as either a mutual fund or an ETF. The key distinction is that ETFs trade like stocks throughout the day on an exchange, while index funds are priced once daily at market close.

Are index funds a good investment for beginners?

Yes, index funds are a popular choice for beginners due to their simplicity, inherent diversification, lower costs and long-term performance potential.

How do I calculate index fund returns?

You can calculate the returns by looking at the change in the fund’s Net Asset Value (NAV) over a timeframe, plus any distributions (dividends). Many online platforms offer an index fund calculator to easily determine historical or projected returns based on your investment amount and time horizon.