Index Funds: What They Are and How They Work

Over the last few decades, a new type of investment has come to dominate the stock market and other types of investments: the index fund. Index funds have even been dubbed “the new kings of Wall Street.”

This is a pretty heady change for an investment tool that was only theoretical for decades, especially since the first one was formed in 1975 and only existed in small numbers for decades thereafter. 

What has made index funds so popular, and what do you need to know about them?

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In this article

    What are index funds?

    To put it in simple terms, an index fund lets you invest in a particular type of investment, matching the average return on that type of investment at a very low cost. What does that mean, though?

    [ More: Thinking About Investing? Start Here First ]

    First, let’s talk about what a mutual fund is. A mutual fund is a type of investment run by a brokerage, where people who want to invest in that fund purchase shares in that mutual fund. Mutual funds are usually invested in stocks, but they can be invested in all kinds of things — bonds, real estate, commodities, currency and agriculture futures.

    The money used to buy those mutual shares is then carefully invested in other things by the team running that mutual fund, with the dividends and profits given back to the people who bought the shares. People do this because they trust the fund managers running the fund to do far better than they would on their own. However, since you’re paying an investment team to do this, mutual funds often have high fees.

    An index fund is a specific type of mutual fund, except that rather than trusting people, instead, the fund invests only in certain types of companies. For example, maybe it invests in small amounts of every publicly traded company, or maybe it invests only in companies with revenue more than $1 billion per year. This requires a lot less management, and thus a lot less in fees. In effect, it’s a good way to match, not try to beat, the overall market in a particular type of investment, and do it at a very low cost.

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    How do index funds work?

    You’re an individual investor, and you’d like to just invest in a certain kind of investment. Maybe you want to own a bit of all the stocks out there to try to match the stock market, or maybe you just want to buy a few of all the big publicly traded companies, or maybe you just want to buy a little of all companies in a certain industry. You can do this yourself, but that’s a lot of work. This is where index funds come in.

    Every index fund out there operates by a very narrow set of rules, like the ones described above. The Vanguard Total Stock Market Index, for example, just buys a little of every publicly traded company. Given that they have such specific rules to operate by, there are actually not many decisions to be made to run such a fund, so it can run with a very lean staff. This keeps costs very low.

    [ Read: How to Get Started Investing in Index Funds ]

    If you want to buy in on an index fund, you simply take your money to a brokerage of some kind and purchase shares in that fund. The cost of a share is based on a small fraction of the value of the investments that are currently owned by that fund. Then, the value of your share will go up and down based on the value of the investments owned by that fund, and you’ll sometimes get dividends as well (usually because the investments in the fund paid out dividends). You can sell these shares when you wish, just like other investments.

    How to choose the right index fund

    If you have money to invest, whether out of pocket or within a retirement account, the idea of an index fund may be intriguing. It’s an efficient and low-cost way to match the market, meaning pretty good returns over the long run. But how do you choose the right index fund? The best place to start is with yourself, particularly your goals and risk tolerance.

    1. Consider your investment goals. Why are you investing? Is your goal something that’s very fixed in time, meaning you have a very specific date you need to hit, or is there flexibility there? For example, you may be investing for retirement. Is there a very specific dollar amount you need to hit, below which would be disastrous? 
    2. How much can you invest? Some index funds have minimum investment requirements. If you’re hoping to deposit only a couple hundred dollars, you may be out of luck with some funds. However, there are low-investment funds available, so be sure that you can meet the minimum investment requirement before you set your heart on a certain fund.,
    3. Think about your risk tolerance. Can you stick with an investment plan if it’s seeing significant short-term losses if you know that, over the long term, the gains outweigh the losses? If you see your balance drop 30%, are you prone to making a rash move with your investments?
    4. Are you ready to invest long-term? Most index funds that have a great average annual rate of return will have individual years that have high losses, which average out with many good years around the bad ones — this is particularly true for stocks. Short-term investors should avoid that kind of risk, as should people who are prone to reactionary investments. 
    5. Look at management fees and rate of return. The management fees are the amount that the investors managing the account remove from the fund in a given year to pay their salaries and maintain the service — lower is usually better from the investor’s perspective. The annual rate of return tells you how much the fund has returned each year in the past — you’ll want to look at the longest timespan available for this number. In general, if annual rates of return are close, choose the fund with the lower management fees.

    How to buy an index fund

    Let’s say that you’ve decided to invest in an index fund. How exactly do you do this? Here are the steps in this process.

    1. Open an investment account. First, you’ll need an account with an investment house. You may already have one — your 401(k) or similar account through your workplace is one such account. A Roth IRA is an investment account with a few special rules for investors saving for retirement, but independent of your workplace. You can also open a general investing account. If you’re looking exclusively at index funds, Vanguard is a great choice — after all, it essentially created the concept and the brokerage is oriented around index funds.
    2. Deposit money into the investment account. The next step is to transfer money into your investment account, typically directly from your checking account. This is usually done via electronic transfer, and you can easily set it up online with your investment account. Note that if you’re using your 401(k) or similar workplace retirement account, you don’t need to do this, as money automatically flows into that account directly from your paycheck.
    3. Make your investment choices. Once the money is in your investment account, you can then use it to purchase shares in the index fund of your choice. With most index fund brokerages, there are many options available to you, so be very aware of your goals and your timeline and risk tolerance to help you filter the index fund options down to a small group, then compare them based on management fees and annual returns.
    4. Purchase the fund. You will find the button on the website or app on the index fund page labeled “buy.” Click that, and you’ll likely be taken to a page to review your order of the index fund. Once everything looks good to go, you can complete the order, which should only take a few minutes. Then you’ll receive a notification on your account that the order has been completed. You now have invested in that index fund.

    Should I invest in index funds?

    Index funds are a great choice if you’re a hands-off investor who doesn’t want to spend a ton of time studying investments but wants a simple choice that will provide consistent solid returns with very little money taken off the top. Index funds, by design, will never beat the market, but they won’t do far worse than the market, either. Rather, by design, they match the market that they’re invested in.

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    However, if you’re an active investor or you have a desire to be particularly aggressive or conservative, index funds may not be a great choice. You don’t need an index fund to hold cash or to buy real estate property, for example, and index funds are not what you’re looking for if you’re a day trader looking to crush the stock market or delve into specific investments with a high level of risk like cryptocurrency.

    We welcome your feedback on this article. Contact us at inquiries@thesimpledollar.com with comments or questions.

    Trent Hamm

    Founder & Columnist

    Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.

    Reviewed by

    • Courtney Mihocik
      Courtney Mihocik
      Loans Editor

      Courtney Mihocik is an editor at The Simple Dollar who specializes in personal loans, student loans, auto loans, and debt consolidation loans. She is a former writer and contributing editor to Interest.com, PersonalLoans.org, and elsewhere.