What is an index fund? Pros, cons and how it can be used in your portfolio
Editorial staff, J.P. Morgan Wealth Management
- An index fund is an investment vehicle, often offered as an ETF or a mutual fund, that tracks the performance of a market index.
- Index funds often come with low fees and built-in diversification, but they may underperform actively managed funds in some periods (though not always).
- You should consider your financial goals and risk tolerance before choosing an index fund to add to your portfolio.
Index funds have grown in popularity as a simple, low-cost way to track the performance of a market index, typically through a passive approach.
Here’s how index funds work, the main types and what to consider before choosing one.
What are index funds?
An index fund is an investment vehicle that tracks the performance of a market index, like the S&P 500. Instead of trying to beat the market, index funds attempt to match the returns of the index they follow by holding the same securities as the index – or a representative sample designed to closely match the index’s performance. For example, an S&P 500 index fund may hold many (or all) of the companies in the S&P 500.
Unlike actively managed funds, which rely on a portfolio manager to buy and sell investments, index funds are generally managed passively, often helping keep costs lower. They can also offer built-in diversification, though the level of diversification depends on the index.
Many index funds are offered as either exchange-traded funds (ETFs) or mutual funds. Both track a specific index, but ETFs trade like stocks throughout the day, while mutual funds are typically bought and sold once per day at the fund’s net asset value (NAV).,
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Types of index funds
Index funds come in many categories. Here are a few common types.
Stock index funds
Stock-focused index funds track a specific stock market index, like the S&P 500 or the Dow Jones Industrial Average. They invest in the same companies as the index – or a representative sample designed to match its performance. These funds may appeal to investors who want equity exposure without picking individual stocks.
Bond index funds
Bond index funds track a bond market index, like the Bloomberg U.S. Aggregate Bond Index. Depending on the index, they may hold government, corporate or municipal bonds. Bond funds may help add stability to a portfolio and provide income, though returns vary.
International index funds
International index funds track indexes outside the U.S., like Japan’s Nikkei 225, the U.K.’s FTSE 100 or Germany’s DAX. They can help diversify beyond U.S. markets while offering broad exposure similar to a U.S. stock index fund. However, they also involve additional risks, including currency fluctuations, political or economic developments, and differences in regulations that can affect returns.
Sector-specific index funds
Sector-specific funds focus on a particular industry or segment of the economy, such as technology, healthcare or real estate. For example, a technology sector index fund may track a technology-focused index from a major index provider. Because these funds focus on a single sector, they can offer targeted exposure without picking individual stocks – though they’re typically less diversified than broad market index funds.
Benefits of investing in index funds
Index funds are a common investment choice for new and experienced investors alike. Here are some of their biggest benefits:
- Low fees and expenses: Because many index funds are passively managed, they often have lower management fees than actively managed funds.
- Reduced risk through diversification: Index funds spread your investment across a range of assets. If you’re invested in a stock-focused index fund, for example, one company’s shares could fall, but the other companies in the fund may help mitigate the negative impact on your portfolio. How diversified an index fund is, though, will vary depending on the index it’s tracking.
- Benchmark-tracking approach: Index funds are designed to match an index’s performance – not beat it – so at their best they tend to track their benchmark over time, though returns can fluctuate with the market.
- Ease of management for investors: Index funds are a largely hands-off investment strategy, so they’re ideal for anyone who isn’t interested in constantly researching companies or making frequent trading decisions.
Potential drawbacks of index funds
Despite the many benefits index funds can offer, there are downsides to consider as well:
- Limited flexibility in investment choices: Index funds are tied to a specific index, so changes are generally driven by the index methodology – not by a manager’s decisions.
- Potential for lower returns: Index funds aren’t trying to beat the performance of an index, so they may underperform actively managed funds at certain times.
- Market risk and volatility: Index funds offer diversification, but they’re still subject to market risk, and some are more volatile than others.
Comparing index funds to other investment options
Before investing in index funds, it can be helpful to see how they stack up against other investment vehicles. Here’s how they compare in terms of cost, risk and level of involvement.
Index funds vs. actively managed mutual funds
Index funds attempt to replicate the holdings of a benchmark index, while actively managed mutual funds rely on professional managers to select investments. Active funds offer the potential for higher returns, but they often involve higher fees and turnover costs.
Index funds vs. individual stocks
Buying individual stocks allows you to invest in specific companies and potentially earn higher returns. This approach also comes with greater risk and requires far more research. A single stock’s performance can be volatile, and choosing the right companies consistently is difficult, even for highly experienced investors.
Index funds, however, offer diversification and reduce the risk tied to investing in any one company. They may not deliver dramatic gains from a single stock, but they can provide broader market exposure and be easier to manage.
Index funds vs. thematic ETFs
Thematic ETFs – sometimes referred to as curated ETFs – focus on specific trends like clean energy or artificial intelligence, which can span multiple sectors. In contrast, sector index funds track the performance of a single sector, such as healthcare or technology, using a rules-based approach.
Thematic ETFs can be actively or passively managed. Actively managed thematic ETFs give fund managers discretion to select companies they believe are positioned to benefit from a particular trend or theme.
While thematic ETFs offer the opportunity to align your portfolio with specific innovations or values, they can be more volatile and less diversified than index funds. They’re best suited for investors who want targeted exposure and are comfortable taking on higher risk in pursuit of growth.
Why index fund returns may differ
Because indexes track different markets and sectors, index fund performance can vary widely. For example, a Nasdaq-100 index fund – often more heavily weighted toward large technology and growth companies – may perform differently from a fund tracking a broader U.S. index, such as the S&P 500.
The S&P 500 is a well-known stock market index that has a long history as a benchmark for large U.S. companies. While past performance doesn’t guarantee future results, S&P 500 index funds are a way for investors to gain broad exposure to the U.S. stock market.
Consider your risk tolerance and investment timeline when evaluating different index funds. Some index funds may be heavily weighted toward specific sectors or companies, especially if the index is market-cap-weighted. Reviewing the fund’s holdings can help you decide if it aligns with your overall financial goals. Not all index funds come with the same return potential, underlying diversification or risk profile, so it’s important to consider the pros and cons of each.
How to invest in index funds
Getting started investing in index funds is pretty straightforward. You’ll need an investment account – be it a general-purpose brokerage account or a tax-advantaged retirement account like an IRA – to buy shares of an index fund.
From there, you can choose which index funds to invest in and decide if you want to invest a lump sum or use dollar-cost averaging (investing a set amount at regular intervals).
Choosing the right index funds
Not all index funds are the same, so it’s important to compare your options before investing. In addition to the underlying investments and objectives, another critical factor to consider is the fund’s expense ratio, which is the annual fee charged by the fund. For passively managed funds, expense ratios can be very low – sometimes just a few basis points – but they vary by fund. That said, while they may seem small, they can have a significant impact on your returns over the long run.
You may also want to check minimum investment requirements (if any) and decide whether you prefer an ETF or a mutual fund. Some investors like mutual funds for features such as automatic, recurring investments, while others prefer the flexibility of ETFs, which trade like stocks.
And to reiterate, you’ll want to understand the index the fund is tracking and what its underlying assets are. Some index funds hold large, well-known companies. Others might include small or mid-sized companies, international stocks or bonds.
Matching your investments to your goals
Your financial goals should guide the types of index funds you choose. If you’re saving for a long-term goal like retirement, stock index funds may be a good fit since they typically offer higher growth potential (and higher volatility) than bond funds. For short-term goals, a mix of stock and bond funds can offer more stability. You should also consider how much risk you’re comfortable taking on.
No matter what you choose, spreading your money across different types of investments can help manage risk during temporary losses in any one area. And while index funds don’t require a lot of daily attention, it’s a good idea to check your portfolio a couple of times a year to ensure your investments still align with your goals.
The bottom line
Index funds can be a low-maintenance way to build wealth over time thanks to their built-in diversification and low fees. But like any investment, you want to choose funds that fit your timeline, risk tolerance and financial goals.
Frequently asked questions about index funds
Every investment comes with some level of risk, but index funds are generally considered less risky than buying individual securities because they spread your money across many holdings. Index funds are only as safe as their underlying assets, though. An index fund tracking the performance of a stock index in an emerging market may be more volatile, for instance, than a broad stock market index fund in a mature economy.
The amount you need to get started depends on the fund – some don’t have any minimum investment requirements, while others may require a set amount to get started.
Yes, index funds can decrease in value just like any investment. While they’re diversified (some more than others), there’s still risk involved.
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