What is an index fund?
An index fund is an investment fund built to track the performance of a specific market index — such as the S&P 500 — by holding the same securities that make up that index, in similar proportions. Because it mirrors an index rather than relying on a manager to pick investments, an index fund can offer broad diversification and typically carries lower costs than an actively managed fund.
How does an index fund work?
An index tracks the performance of a specific group of investments — the S&P 500, for example, follows 500 of the largest U.S. publicly traded companies. An index fund aims to mirror that group by holding the same underlying securities, so the fund’s return generally moves in line with the index it follows — minus applicable fees.
Index funds typically follow a rules-based approach — it holds what the index holds, instead of a portfolio manager researching and picking individual stocks to try to beat the market. That hands-off approach is called passive investing. According to the U.S. Securities and Exchange Commission’s Investor.gov, index funds are designed to track a market index and generally have lower expenses than actively managed funds because they require less day-to-day trading and research.
Index funds come in two common forms: traditional index mutual funds and index exchange-traded funds (ETFs). Both can track the same index, but they differ in how you buy and hold them — covered in more detail below.
Because an index fund tracks the whole index, its value rises and falls with that segment of the market. In a market downturn, an index fund that tracks a falling index declines along with it. Index funds are designed for broad market exposure, not for shielding a portfolio from losses.
Index fund vs. ETF: what’s the difference?
An index fund and an ETF aren’t competing choices — an index fund can be either a traditional mutual fund or an ETF. The real comparison is between an index mutual fund and an index ETF, and the practical differences come down to how they trade, what they cost, their minimums, and their tax treatment:
| Dimension | Index mutual fund | Index ETF |
| How it trades | Once per day, priced at the close (NAV) | Throughout the day, like a stock |
| Minimum investment | May require a set minimum | Typically the price of one share — or less, where fractional shares are offered |
| Costs | Expense ratio; some funds may carry additional fees | Expense ratio; you may also pay a bid-ask spread when trading |
| Taxes (taxable accounts) | Can generate taxable capital gains distributions | Structure can produce fewer taxable distributions |
What those terms mean:
- NAV (net asset value): the fund’s per-share price, calculated once a day after the market closes.
- Expense ratio: the fund’s annual fee, charged as a percentage of the amount you have invested.
- Bid-ask spread: the small gap between an ETF’s buy and sell price that you may cross when trading during the day.
- Taxes: an ETF’s structure can let it limit the capital gains it passes to shareholders at year-end, so it can be more tax-efficient than a mutual fund — which may distribute those gains, potentially creating a tax bill even in a year you didn’t sell.
Neither structure is universally better — the right fit depends on how you plan to invest, the account you hold it in, and your own tax situation. For a fuller explanation of the exchange-traded structure, see what ETFs are. For a broader look at the tradeoffs of tracking the market, see the pros and cons of index investing.
What are the benefits and drawbacks of index funds?
Index funds are popular for a few clear reasons — but each benefit comes with a limit worth understanding:
- Diversification. A single index fund can hold hundreds or thousands of securities, which spreads exposure across many companies. Diversification can reduce the impact of any one holding, but it does not ensure a profit or eliminate market risk — a broad market decline can still affect the whole fund.
- Lower costs. Because index funds track rather than actively select, they generally carry lower expense ratios than actively managed funds (Investor.gov). Lower costs mean more of a return may stay invested — though costs are only one factor, and fees still apply and can reduce returns over time. Learn more about how fees can impact your portfolio with M1’s Compounding Cost Calculator.
- Simplicity. Index funds offer a straightforward way to gain broad exposure without researching individual stocks. That simplicity comes with a tradeoff: an index fund is built to match its index, not to beat it, so it is not designed to outperform the market it tracks.
No investment removes risk. An index fund can lose value, and past performance does not indicate future results.
Where M1 fits
On M1, index funds and index ETFs can sit inside a Pie — M1’s customizable portfolio — alongside other holdings, and M1’s fractional shares let you put a whole dollar amount to work rather than buying in whole-share increments.
Frequently asked questions about index funds
Index funds are investment funds that track a market index by holding the securities in that index. They provide broad, diversified exposure to a segment of the market and typically cost less than actively managed funds.
An index fund is a type of fund defined by its strategy — tracking an index. A mutual fund is a structure for pooling investor money. An index mutual fund is both. Not all mutual funds are index funds; many are actively managed, which generally costs more. The right choice depends on your goals and costs, not on the label alone.
The main ongoing cost is the expense ratio — an annual percentage of assets. Index funds generally have lower expense ratios than actively managed funds, but costs vary by fund, and additional fees may apply depending on where you hold the fund. Even small fees can reduce returns over time, so it can help to compare a fund’s total costs before investing.
Whether any index fund fits depends on your goals, time horizon, and risk tolerance. Index funds can offer diversification and low costs, but they also carry market risk and are designed to match rather than beat the market. Some investors use them as a core holding; others combine them with other investments. Consider your own situation, and investing involves risk, including possible loss of principal.
Investing involves risk, including the possible loss of principal. This content is for educational and informational purposes only and is not investment, tax, or financial advice. Index funds are subject to market risk and will fluctuate in value.
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