How Do Index Funds Work?


Disclaimer: This is not financial advice, educational purposes only

Index Funds are a great tool to build wealth passively at a relatively low cost

If you’re interested in investing but don’t want to deal with the complex market, expensive fees and the hassles of active management then index funds could be an ideal solution for you.


What is an Index?

An Index isn’t anything fancy, it is really just a benchmark to see how that sector or group of assets are doing.

Here are some of the most popular stock market indexes:

  • Dow Jones Industrial Average – The Dow Jones (DJIA) tracks the performance of the top 30 companies in the United States
  • S&P 500 – The S&P 500 is a stock market index that tracks the top 500 companies in the United States. This one of the most popular as this covers about 85% of the total stock market
  • Nasdaq – The Nasdaq composite includes the top 100 non-financial public companies. You can invest in the Nasdaq through QQQ

What is an Index Fund?

An index fund is essentially a type of mutual fund or an exchange-traded fund (ETF) that consists of a portfolio of stocks and bonds.  It is designed to replicate the performance of a market financial index, the most common one being the S&P 500.

Index funds are passively managed, so they don’t require an investment team to be actively trading. Instead, index funds match the investments of the index it is tracking. This allows investors to have a relatively hands off approach with their investments.

So heres how it works.. 

Let’s say you invest in a fund that tracks the S&P 500.  The investment manager tracks the S&P and purchases the same investments as the index so as the S&P 500 grows so will your investment. Rather than these fund managers trying to “beat” the market by picking their own investments, they are simply trying to mirror the performance of the index.

Let’s look at VTSAX, a very popular Vanguard Index Fund that tracks the total stock market. Over the past 10 years, the stock market returned an average of 13.9% and VTSAX return 13.5%.  It is able to essentially match the return of the total stock market by mirroring its investments

Why Should I Care about Index Funds?

Since index funds are passively managed and mimic the performance of market financial indexes, this makes them to be very desirable investments.

Some of the advantages of investing in an index fund, include lower management costs, broader market exposure, tax benefits and more reliable returns. These are ideal for any passive investor who want to set it and forget it.

Here are some reasons why investors love index funds:

1. Lower Management Fees

Since index funds are passively managed and don’t need analysts and investments managers to be actively trading, they charge much (and I mean muuuuuch) lower fees. 

The expense ratio, the administrative fee charged to investors for the operating of a fund, for an index fund can be as low as 0.02% while an expense ratio of 1% is not unusual for an active mutual fund. Not only does a lower expense ratio mean that you will pay lower fees on your investments, it also has an impact on the performance of your investment as funds with lower expense ratios tend to maintain their benchmarks more easily over the long term.

As index funds are linked to market financial indexes, they do not require analysts or other professionals that contribute to the overall process. Market financial indexes tend to not change often, so managers trade investments relatively rarely which reduces commissions and transaction fees, thus decreasing overall operating expenses even further.

Essentially, index funds cost less to manage because of their very automated nature.

2. No reliance on Management

The great benefit of having your investment linked to a financial market index like the S&P 500 is that the opportunity for human error is pretty small. You don’t have to worry about finding the right manager and hoping that they are somehow intelligent enough to beat the market.  

Instead,  with a passive index fund you are focusing on just matching the market. This is great for people who want to invest but don’t want to have to put in too much work.

3. Better Long-Term Returns

The basic philosophy behind the index fund is that the market always wins long term, so it’s best to mimic it as much as possible.  Over the course of the long-run the total gain from investing in index funds exceeds what other types of mutual funds can provide.

The  low expense ratio is also a fact that contributes to the long-term success of index funds. Additionally, the broad market diversification makes it increasingly likely that you’ll be protected against any major losses.

It can be said that in the very long term you could earn a greater return on your investment through opting for an index fund. Although you’ll need a lot more patience with an index fund, the greater long-term benefits certainly do offer better long-term prospects, especially if you want to avoid risks as much as possible.  With passively managed funds there are relatively few transactions is that index funds reduce tax exposure.

4. Reduced Tax Exposure

Index funds are considered to be tax-efficient because they are not actively traded

As explained above, index funds trade securities far less often than other kinds of funds since they are not actively trading, this means that they tend to generate less income a low turnover ratio which translates to a lower capital gains tax.

Investing index funds helps you avoid short term capital gains tax as each security in the fund in usually held for a longer period of time. Long term capital gains taxes are far more favorable to investors than short-term ones, a deliberate policy measure designed by the IRS to encourage people to invest more in the long term. Since index funds provide gains over a longer period of time, you’ll pay less in capital gains tax.

Popular Index Funds with Low Fees:

It is recommended to purchase index funds from the brokerage that owns it. For example, if you want to invest in VFIAX you will most likely need to purchase via Vanguard. If not, you may incur an additional fee when placing your investment. 

Low Cost Mutual Fund Index Funds that track the S&P 500:

1. (VFIAX) Vanguard 500 Index Fund

10 Yr Average Annual Return: 13.85%

Expense Ratio: 0.04%

Minimum Investment: $3,000

2. (SWPPX) Schwab S&P 500 Index Fund

10 Yr Average Annual Return: 13.43%

Expense Ratio: 0.02%

Minimum Investment: $1

3. (FXIAX) Fidelity S&P 500 Index Fund

Average Annual Return: 13.6%

Expense Ratio: 0.015%

Minimum Investment: $1,000


Low Cost Mutual Fund Index Funds that track the Total Stock Market: 

1.  (VTSAX) Vanguard Total Stock Market Index Fund

Average Annual Return: 13.5%

Expense Ratio: 0.04%

Minimum Investment:  $3,000

2. (SWTSX) Schwab Total Stock Market Index Fund

Average Annual Return: 13.44%

Expense Ratio: 0.03%

Minimum Investment:$0 

3. (FSKAX) Fidelity Total Stock Market Index Fund

Average Annual Return: 13.46%

Expense Ratio: 0.015%

Minimum Investment: $0


In conclusion, index funds are a relatively safe investment tool that is favoured by many for the fact that they produce reliable gains over the long term, cost relatively less, reduce tax exposure and eliminate the needed for acquiring financial expertise.

Hopefully, this guide will have helped you to decide whether or not you want to invest in index funds by educating you on all of the benefits of doing so

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Jess | Millennial Money Expert

I saved $100K at 25 and I help millennials and gen z-ers get excited about financial literacy and build wealth. 

You have probably heard myself or other personal finance influencer's speak about how great low cost index funds are as a tool to build wealth, but what even are they and how does it work? If you’re interested in investing but don’t want to deal with the complex market, expensive fees and the hassles of active management then index funds could be an ideal solution for you.