The Lowdown on Index Funds

Find out why these investments are so popular

Reviewed by Thomas Brock

Index funds provide investors with a return that is directly linked to individual markets while charging minimal amounts for expenses. Despite their benefits and growing popularity, not everyone knows precisely what index funds are—or how they compare to the many other funds offered by the marketplace. Here, we take a closer look and track how they perform over time compared with actively managed investments.

Key Takeaways

• Index investing has seen a massive rise in popularity over the past decade, with billions of dollars of investor money pouring into index mutual funds and ETFs.
• Indexing is a passive investment strategy that seeks to replicate an index and match its performance, rather than trying to actively pick stocks and beat the index’s benchmark.
• Index investing features lower fees, greater tax efficiency, and broad diversification.
• Research shows that over the long run, passive indexing strategies tend to outperform their active counterparts.

Active vs. Passive Management

Before we get into the details of index funds, it’s important to grasp the two prevailing styles of mutual fund management: passive and active.

Most mutual funds fit in the active-management category. Active management involves the twin arts of stock picking and market timing.

This means that the fund manager puts their skills to the test in trying to pick securities that will outperform the market. Since actively managed funds require more hands-on research, and because they experience higher trading volumes, their expenses are naturally higher.

Passively managed funds, on the other hand, do not attempt to beat the market. A passive strategy instead seeks to match the risk and return of the broad stock market or a segment of it. You can think of passive management as the buy-and-hold approach to money management.

What Is an Index Fund?

An index fund is passive management in action: It’s a mutual fund that attempts to mimic the performance of a particular index. For instance, a fund tracking the S&P 500 index would own the same stocks as those in the S&P 500. It’s as simple as that! These funds believe that tracking the market’s performance will produce a better result as compared with the other funds.

Remember, when people talk about “the market,” they are most often referring to either the Dow Jones Industrial Average or the S&P 500. There are, however, numerous other indexes that track the market, such as the Nasdaq Composite, Wilshire Total Market Index, Russell 2000, and so on.

Note

Exchange-traded funds (ETFs) are good options for investing in index funds, especially as they generally come with lower expense ratios than mutual funds.

What Benefits Does Indexing Provide?

There are two main reasons why somebody chooses to invest in an index fund. The first is related to an investing theory known as the efficient market hypothesis.

This theory states that all markets are efficient and that investors can’t gain larger-than-normal returns because all relevant information that may affect a stock’s price is already incorporated into its price. And so, index fund managers and their investors believe that if you can’t beat the market, you might as well join it.

The second reason to choose an index fund has to do with the low expense ratios. Typically, the range for these funds is around 0.06% on average, which is much lower than the 0.68% average often seen for actively managed funds. Yet the cost savings don’t stop there. Index funds don’t have the sales charges known as loads, which many mutual funds do.

In bull markets, when returns are high, investors may not pay these ratios much heed; however, when bear markets come around, the higher expense ratios become more conspicuous, as they are directly deducted from the now meager returns. For example, if the return on a mutual fund is 10% and the expense ratio is 3%, the real return for the investor is only 7%. 

What Are You Missing Out On?

One of the major arguments of active managers is that by investing in an index fund, investors are giving up before they have even started. These managers believe that the market has already defeated investors who are buying into these types of funds.

Since an index fund will always earn a return identical to that of the market it is tracking, index investors won’t participate in any anomalies that may occur. For instance, during the tech boom of the late ’90s, when the stocks of new technology companies reached record highs, index funds were unable to match the record returns of some actively managed funds.

Meanwhile, actively managed funds that become enamored of the darling stocks of the moment during a sector boom (or bubble) may profit handsomely. They may also regret it bitterly in the event of a bust (or burst).

The advantage of an index is that it’s much more likely to recover than any individual stock. For example, an index fund tracking the S&P 500 in 2008 would have lost about 37% of its value that year in the financial crisis. However, the index rose about 26.5% the following year and 15% in 2010.

What Are the Results?

Generally, when you look at fund performance over the long run, you can see a trend that actively managed large-cap U.S. equity funds have mostly underperformed the S&P 500 index. From 2001 to 2023, there were only three years (2001, 2007, and 2009) where a majority of active funds outperformed the S&P 500. Note that those years coincide with financial crashes (the dot-com bubble crash and the financial crisis of 2007-2009).

What Is an Index Fund?

An index fund is an investment fund that tracks an index as its benchmark. For example, an index fund might track the Nasdaq 100 index. It would purchase the stocks that are in the index intending to replicate its returns. Investors seeking exposure to the Nasdaq 100 could then invest in this fund.

Is the S&P 500 an Index Fund?

No, the S&P 500 is not an index fund. It is only a stock market index. The S&P 500 groups together the largest 500 companies in the U.S. by market cap. You cannot invest in the index, it simply tracks these companies. You can, however, invest in an index fund that uses the S&P 500 index as its benchmark. Many funds do this, such as the SPDR S&P 500 ETF. This fund seeks to replicate the returns of the S&P 500.

Are Index Funds Better Than 401(k)s?

Index funds and 401(k)s are different investment vehicles but share some similarities. Index funds track a stock market index. Investors seeking returns of a specific index can invest in an index fund that tracks that index. Money can be taken out at any time. 401(k)s are retirement vehicles that come with restrictions.

For example, unless there are special circumstances, money cannot be withdrawn till retirement. 401(k)s are tax-advantaged, meaning they provide a tax benefit when investing, whereas index funds do not. Furthermore, 401(k)s invest in funds, and often invest in index funds. So if you invest in a 401(k), you are most likely investing in some type of index fund.

The Bottom Line

It’s true that over the short term, some mutual funds will outperform the market by significant margins; but over the long term, active investment tends to underperform passive indexing, especially after taking into account fees and taxes.

Picking those high performers from the literally thousands out there is almost as difficult as picking stocks yourself. Whether or not you believe in efficient markets, the costs that come with investing in most mutual funds make it very difficult to outperform an index fund over the long term.