What Is an Index Fund? — In Plain Words

What Investor.gov says an index fund is

Investor.gov’s glossary entry “Index Fund” says: “An index fund is a mutual fund, exchange-traded fund (ETF), or unit investment trust (UIT). These funds follow a passive investment strategy designed to achieve approximately the same return as a particular index before fees.”

The same glossary entry says: “An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in the selected index.” It adds that some index funds may also use derivatives (like options or futures) to help achieve their investment objective, or invest in a representative sample of the companies included in an index.

Investor.gov’s Investor Bulletin “Index Funds” words the definition slightly differently. It says: “An ‘index fund’ is a type of mutual fund or exchange-traded fund that seeks to track the returns of a market index.” That bulletin does not mention unit investment trusts in that sentence. See the “Where the sources differ” box below.

Investor.gov’s glossary entry “Passive Fund or Passively Managed Fund” says passively managed mutual funds, ETFs, and UITs are also called index funds.

What FINRA says an index fund is

FINRA’s pages read for this page talk about index funds inside its material on mutual funds. FINRA’s “Mutual Funds — Types” page says: “Stock index funds are passively managed funds that attempt to replicate the performance of a specific stock market index by investing in the stocks held by that index.”

FINRA’s “Mutual Funds” page, in its “Active vs. Passive” section, says: “These are passively managed funds, otherwise known as index funds.” In that sentence, FINRA is describing funds that don’t try to beat the market at all.

FINRA’s “Mutual Funds” page also says, in its opening list, that each mutual fund has a different investment objective, and that some funds invest in a particular product, such as stocks or bonds, some focus on a particular industry or region, and others seek to replicate a market index.

Gap disclosed: on the FINRA pages read in full for this page, FINRA does not give a stand-alone definition that describes an index fund as an exchange-traded fund or a unit investment trust, and it does not describe a bond index fund in those words. Its index-fund wording on those pages is framed through mutual funds, and through stock index funds in particular. Investor.gov’s glossary wording is broader. This page prints both as they stand and does not fill the gap.

What a market index is, in the sources’ words

Investor.gov’s Investor Bulletin “Index Funds” says: “A market index measures the performance of a ‘basket’ of securities (like stocks or bonds), which is meant to represent a sector of a stock market, or of an economy. You cannot invest directly in a market index, but because index funds track a market index they provide an indirect investment option.”

That bulletin names examples of market indexes that index funds may seek to track: the S&P 500 Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index. Those names are printed here only as Investor.gov’s own examples, in its bulletin. They are not a recommendation of any index or any fund.

FINRA words the related idea as a benchmark. FINRA’s “Mutual Funds” page says each fund is measured against an appropriate market index, or benchmark, based on its stated investment strategy and the types of investments it makes. As its own examples, FINRA says many large-cap stock funds typically use the S&P 500 Index as the benchmark for their performance, and a fund that invests in stocks across market capitalizations might use the Dow Jones Wilshire 5000 Total Stock Market Index. Those names are FINRA’s own examples, printed with FINRA’s attribution. They are not a recommendation.

The mutual fund underneath, in brief

Because both sources discuss index funds alongside mutual funds, this short section gives only the sources’ own background on what a mutual fund is. It is background, not a second lesson.

Investor.gov’s glossary entry “Mutual Funds” says: “A mutual fund is an SEC-registered open-end investment company that pools money from many investors. It invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments.” It says the combined holdings the mutual fund owns are known as its portfolio, which is managed by an SEC-registered investment adviser, and that each mutual fund share represents an investor’s part ownership of the mutual fund’s portfolio and the income the portfolio generates.

FINRA’s “Mutual Funds” page says a mutual fund is a type of investment company, known as an open-end fund, that pools money from many investors and invests it based on specific investment goals, and that the holdings of the mutual fund are known as its underlying investments, and the performance of those investments, minus fund fees, determine the fund’s investment return.

Investor.gov’s “Mutual Funds” page lists dividend payments as one of the three ways investors can make money from mutual fund investments, describing a dividend payment as income from the fund’s portfolio that the fund pays to shareholders. For that word itself, see the sibling page in this program called what-is-a-dividend-in-plain-words.

How an index fund tries to track its index — Investor.gov

Investor.gov’s Investor Bulletin “Index Funds” says index funds may take different approaches to track a market index: some invest in all of the securities included in a market index, while others invest in only a sample of the securities included in a market index.

The same bulletin explains weighting. It says market indexes often use a company’s market capitalization to decide how much weight that security will have in the index, and it defines market capitalization (or “market cap”) as a measure of the total value of the company’s shares, equal to the share price times the number of shares outstanding. It says that in a market-cap-weighted index, securities with a higher market capitalization value account for a greater share of the overall value of the index. It also says some market indexes, such as the Dow Jones Industrial Average, are “price-weighted,” and in that case the price per share will determine the weight of a security.

The bulletin also says some index funds may also use derivatives (like options or futures) to help achieve their investment objective.

How an index fund tries to track its index — FINRA

FINRA’s “Mutual Funds” page says: “Passive funds seek to replicate the performance of their benchmarks instead of outperforming them.”

FINRA then gives its own process example, using the S&P 500. FINRA says the manager of an index fund that tracks the performance of the S&P 500 typically buys a portfolio that includes all of the stocks in that index in the same proportions as they are represented in the index. FINRA says if the S&P 500 were to drop a company from the list, the fund would sell its shares in that company, and if the S&P 500 were to add a company, the fund would buy that company’s stock.

That add-and-drop example is FINRA’s. Investor.gov’s Investor Bulletin “Index Funds,” as read in full, does not give that add-and-drop example. Investor.gov’s bulletin instead explains weighting by market capitalization and by price, as printed in the section above. FINRA’s pages, as read in full, do not give that weighting explanation in their index-fund sections.

Passive and active, in each source’s words

Investor.gov’s Investor Bulletin “Index Funds” says index funds have generally followed a passive, rather than active, style of investing, and that this means they aim to maximize returns over the long run by not buying and selling securities very often. It says, in contrast, an actively managed fund often seeks to outperform a market (usually measured by some kind of index) by doing more frequent purchases and sales.

Investor.gov’s glossary entry “Index Fund” says passive management usually translates into less trading of the fund’s portfolio (lower transaction costs), more favorable income tax consequences (lower realized capital gains), and lower fees and expenses than actively managed funds.

FINRA’s “Mutual Funds” page says when a fund is actively managed, it employs a professional portfolio manager, or team of managers, to decide which underlying investments to choose for its portfolio, and that the goal of an active fund manager is to beat the market — to get better returns by choosing investments that they believe to be top-performing selections. FINRA then describes passively managed funds, otherwise known as index funds, as funds that don’t try to beat the market at all.

Costs — Investor.gov says

Investor.gov’s Investor Bulletin “Index Funds” says that because index funds generally use a passive investing strategy, they may be able to save costs. As its example, it says managers of an index fund are not actively picking securities, so they do not need the services of research analysts and others that help pick securities, and that this reduction in the cost of fund management could mean lower overall costs to shareholders.

The same bulletin then prints this caution, in Investor.gov’s own words: “However, keep in mind that not all index funds have lower costs than actively managed funds. Always be sure you understand the actual cost of any fund before investing.”

Investor.gov’s glossary entry “Index Fund” also says: “Over time, higher fees and expenses can significantly lower investment returns.” Investor.gov’s “Mutual Funds” page says fees vary from fund to fund, that even small differences in fees can mean large differences in returns over time, and that a fund with high costs must perform better than a low-cost fund to generate the same returns for you.

For the cost term used for a fund’s yearly operating costs as a percentage, see the sibling page in this program called what-is-an-expense-ratio. This page does not re-teach that term.

Costs — FINRA says

FINRA’s “Mutual Funds” page says: “Because index funds don’t need to retain active professional managers, and because their holdings aren’t as frequently traded, they normally have lower operating costs than actively managed funds. However, the fees vary from index fund to index fund, which means the return on these funds varies as well.”

FINRA’s “Mutual Funds” page also says all mutual funds have fees and expenses, and all mutual funds charge fees and expenses, some of which you pay directly (like sales charges and redemption fees) and others that come out of the fund’s assets. It says these fees and expenses can vary widely from fund to fund or fund class to fund class, and that even small differences in expenses might make a big difference in your return over time.

FINRA’s page names its own tool for comparing fund costs, called FINRA’s Fund Analyzer. This page only names that tool, as FINRA names it. This page has no tool, no form, and no calculator of its own.

Risks — Investor.gov says

Investor.gov’s Investor Bulletin “Index Funds” says: “Like any investment, index funds involve risk. An index fund will be subject to the same general risks as the securities in the index it tracks.”

The bulletin then names certain other risks, in its own list:

• Lack of Flexibility. The bulletin says an index fund may have less flexibility than a non-index fund to react to price declines in the securities in the index.
• Tracking Error. The bulletin says an index fund may not perfectly track its index. As its example, it says a fund may only invest in a sampling of the securities in the market index, in which case the fund’s performance may be less likely to match the index.
• Underperformance. The bulletin says an index fund may underperform its index because of fees and expenses, trading costs, and tracking error.

Investor.gov’s “Mutual Funds” page adds general mutual fund risk wording. It says mutual funds are not guaranteed or insured by the FDIC or any other government agency, that they therefore all carry some level of risk, and that you may lose some or all of the money you invest because the investments held by a fund can go down in value. It also says a fund’s past performance does not predict future returns, and that generally, the higher the potential return, the higher the risk of loss.

Risks — FINRA says

FINRA’s “Mutual Funds” page says mutual funds are a popular way to invest in securities, and that because mutual funds can offer built-in diversification and professional management, they offer certain advantages over purchasing individual stocks and bonds, but that, like investing in any security, investing in a mutual fund involves certain risks, including the possibility that you might lose money.

Later on the same page, FINRA says that because most mutual funds offer a level of built-in diversification, they’re typically considered a lower risk investment, but that, as with all investments, there are still risks involved, and mutual fund returns aren’t guaranteed. FINRA also says mutual funds also assume some of the risks of the assets that they hold.

FINRA’s “Mutual Funds” page then gives general mutual fund risk sections headed Inflation Risk, Interest Rate Risk, Liquidity Risk, and Market Risk. Those sections are worded for mutual funds in general, not for index funds in particular. This page does not restate them as index-fund risks.

Gap disclosed: on the FINRA pages read in full for this page, FINRA does not name tracking error, lack of flexibility, or underperformance against its own index as risks of an index fund. Those three named risks on this page come from Investor.gov’s Investor Bulletin “Index Funds” only.

A FINRA-only point: enhanced index funds

FINRA’s “Mutual Funds” page says some index funds, which go by names such as enhanced index funds, are hybrids. It says their managers pick and choose among the investments tracked by the benchmark index in order to provide a superior return. It says in bad years, this hybrid approach might still be able to produce positive returns or returns that are slightly better than the overall index. It also says it’s always possible that this type of hybrid fund won’t do as well as the overall index, and that the fees for these enhanced funds might be higher than the average for index funds.

Investor.gov’s Investor Bulletin “Index Funds,” as read in full, does not describe enhanced index funds. Its opening note says that bulletin provides basic information about how index funds, which have traditionally tracked market indexes, work, and that the information in it may not apply to newer types of index funds that track custom-built indexes or benchmarks, which it calls “non-traditional” index funds, and it points readers to a separate bulletin for those products. This page does not teach that separate non-traditional material.

Before you invest, in the sources’ words

Investor.gov’s Investor Bulletin “Index Funds” says, before investing in any fund, you should carefully read all of the fund’s available information. It says this includes the fund’s prospectus and most recent shareholder report, and that, in addition, funds disclose their portfolio holdings quarterly. It says you can typically get this information from the fund’s website or your financial professional, as well as on EDGAR.

The bulletin lists questions that, in its words, asking might help. Printed here in full, they are:

• What fees and expenses can I expect to pay for buying, owning, and selling this fund?
• What specific risks are associated with this fund?
• How is the makeup of the fund’s index determined?
• How does the fund’s investment strategy fit with my investment goals?

FINRA’s “Mutual Funds” page says it’s important to read a mutual fund’s prospectus to learn about its objectives, investments, strategies and costs. It also says all of the details about a mutual fund — including its investment strategy, risk profile, performance history, management and fees — are provided in its prospectus, and that you should always read the prospectus before investing in a fund.

A related page

This program also has a companion page called etf-vs-mutual-fund-the-difference-in-plain-words, from batch #29. That page covers how exchange-traded funds and mutual funds compare. This page does not repeat that comparison. Read that page for the comparison, and read this page for what an index fund itself is.

What this page does not cover

This page does not say whether any fund is a good fund, and it gives no cost level, fee level, or return level as “good” or “bad.” Neither anchor, on the pages read in full, gives such a threshold for an index fund, and this page does not invent one.

This page does not pick stocks, does not pick funds, and does not recommend any named fund, any named index, or any company. Index names printed on this page appear only inside the anchors’ own examples, with attribution.

This page does not teach non-traditional index funds, such as the smart beta, quant, and ESG funds covered in Investor.gov’s separate bulletin on non-traditional index funds, or the non-traditional index funds covered in FINRA’s separate article on that topic. It only notes that those separate materials exist.

This page does not cover how to buy or sell a fund, taxes on a fund in detail, fund share classes, sales charges called loads, or retirement accounts. FINRA’s and Investor.gov’s pages touch some of those topics for mutual funds in general. Read the sources in the Sources box below for their full wording on anything this page leaves out.

This page gives no advice about any person’s own money.

Words to know

Index fund: In Investor.gov’s glossary words, a mutual fund, exchange-traded fund (ETF), or unit investment trust (UIT) that follows a passive investment strategy designed to achieve approximately the same return as a particular index before fees. In FINRA’s words for stock index funds, a passively managed fund that attempts to replicate the performance of a specific stock market index by investing in the stocks held by that index.

Market index: In Investor.gov’s bulletin words, a measurement of the performance of a “basket” of securities (like stocks or bonds), which is meant to represent a sector of a stock market, or of an economy.

Benchmark: In FINRA’s usage on its “Mutual Funds” page, the appropriate market index a fund is measured against, based on its stated investment strategy and the types of investments it makes.

Passive / passively managed: In Investor.gov’s bulletin words, a style of investing that aims to maximize returns over the long run by not buying and selling securities very often. Investor.gov’s glossary says passively managed mutual funds, ETFs, and UITs are also called index funds.

Actively managed: In Investor.gov’s bulletin words, a fund that often seeks to outperform a market by doing more frequent purchases and sales. In FINRA’s words, a fund that employs a professional portfolio manager, or team of managers, to decide which underlying investments to choose for its portfolio.

Tracking error: In Investor.gov’s bulletin words, the risk that an index fund may not perfectly track its index.

Representative sample: In Investor.gov’s glossary and bulletin usage, investing in only a sample of the securities or companies included in an index, instead of all of them.

Expense ratio: In FINRA’s words on its “Mutual Funds” page, the fund’s total annual fund operating expenses — the percentage of the fund’s total assets that goes toward paying its recurring fees every year, found in a fund’s prospectus, on the fund’s website, or in financial publications.

Prospectus: In FINRA’s words, the document that provides all of the details about a mutual fund, including its investment strategy, risk profile, performance history, management and fees.

This page is general information only. It is not financial advice.

Only the fund’s own prospectus and the sources above can speak to a specific fund. This page decides nothing about any fund.