When I opened my first brokerage account in 2018 with $200, I spent three hours trying to figure out which stocks to buy. Then I read that 80–89% of professional fund managers underperform the S&P 500 over ten years, and I realized I was approaching this backward. I didn’t need to pick winners. I needed to own a slice of everything — and that’s what an index fund does.
The short answer
An index fund is a type of investment fund that buys all (or most) of the stocks or bonds in a specific market index — like the S&P 500 or the total U.S. stock market — so your investment automatically tracks that index’s performance. Instead of trying to beat the market, you match it, usually at very low cost.
What is an index fund, exactly
An index fund is a pooled investment that follows a preset list of securities. If the index it tracks includes 500 companies, the fund buys shares in all 500, weighted by their size. When you buy into the fund, you own a tiny fraction of that entire basket.
The most common example is an S&P 500 index fund. The S&P 500 is a list of 500 large U.S. companies maintained by S&P Global. An S&P 500 index fund holds shares in all of them — Apple, Microsoft, ExxonMobil, Walmart, and 496 others — in proportion to their market capitalization. If Apple makes up 7% of the index, it makes up roughly 7% of the fund.
Index funds exist for nearly every asset class: U.S. stocks, international stocks, bonds, real estate investment trusts, even commodities. The fund’s only job is to mirror the index as closely as possible. It doesn’t try to pick which companies will outperform or avoid the ones that won’t. It just owns them all.
How index funds work under the hood
The mechanics are simpler than most people assume. A fund manager — or more often, an algorithm — buys the securities in the index in the correct proportions. When the index changes (a company gets added or removed, or a company’s market cap shifts), the fund rebalances to match.
This happens with very little trading. Because the fund isn’t making bets, it’s not constantly buying and selling. That keeps costs low and tax consequences minimal compared to actively managed funds, which may turn over 50–100% of their holdings each year.
Index funds charge an expense ratio — the annual fee expressed as a percentage of your investment. As of 2024, the average equity index fund charges between 0.03% and 0.20% per year, according to Morningstar. That means if you invest $10,000, you might pay $3 to $20 annually. By contrast, actively managed mutual funds average 0.44% to 0.66%, which adds up significantly over decades.
Here’s what that difference looks like. Assume you invest $10,000 and earn an average 7% annual return (the inflation-adjusted historical average for the S&P 500). After 30 years:
- At 0.05% fees: ~$75,000
- At 0.50% fees: ~$67,000
- At 1.00% fees: ~$61,000
The lower-fee fund leaves you with $14,000 more — just from avoiding the drag of higher costs.
Index funds vs mutual funds: the key difference
This is where beginners get confused, because an index fund is a type of mutual fund. The distinction is in strategy, not structure.
A mutual fund is just a pooled investment vehicle, as explained in the SEC’s investor education materials. It can be actively managed (a human or team picks the stocks) or passively managed (it follows an index). Most mutual funds are actively managed. They charge higher fees because they’re paying analysts, researchers, and portfolio managers to make decisions.
An index fund is a passively managed mutual fund (or ETF — more on that in a moment) that tracks an index. It doesn’t employ stock pickers. It doesn’t try to beat the market. It tries to match it.
Index funds can also be structured as ETFs (exchange-traded funds), which trade like stocks throughout the day. Traditional index mutual funds are priced once per day at market close. For most long-term investors, this distinction doesn’t matter much. The underlying strategy — passive, low-cost, index-tracking — is the same.
The interesting wrinkle: most professionals lose to the index
This is the part that surprises people. According to S&P Global’s SPIVA (S&P Indices Versus Active) scorecard, 88% of U.S. large-cap active managers underperformed the S&P 500 over the 10 years ending 2023. Over 15 years, the figure is 92%.
These aren’t amateurs. These are credentialed analysts with Bloomberg terminals and research teams. And they still lose, on average, to the index.
The reasons are structural. Active funds have higher fees, higher turnover, and the difficult reality that for every trade that beats the market, someone on the other side of that trade loses. In aggregate, active managers are the market — minus their fees.
This is why index funds have become the default recommendation for beginner investors. You’re not giving up much upside, and you’re avoiding a lot of downside risk in the form of fees and underperformance.
Where to buy index funds
The “how do I actually start” question trips up more beginners than the concept itself. You buy index funds through a brokerage account. Here’s where most people open them:
Vanguard — The company that invented the first index fund for individual investors in 1976. Many of their index funds have $1,000 or $3,000 minimums for mutual fund shares, but $0 minimums if you buy the ETF version.
Fidelity — Most Fidelity index funds have $0 minimums and no transaction fees if you’re buying Fidelity funds through a Fidelity account.
Charles Schwab — Similar to Fidelity: $0 minimums on Schwab index funds, no commissions on their own fund lineup.
All three offer commission-free trading on most ETFs, including their own index fund ETFs. That means if you have $100 to invest, you can buy a fractional share of an ETF with no transaction cost.
Some investors prefer their 401(k) provider’s platform if it offers low-cost index options. Others use robo-advisors, which build portfolios from index funds automatically.
You’ll need to open an account (online, takes 10–15 minutes), link a bank account, transfer money, then search for the fund by its ticker symbol or name. The first time feels intimidating. The second time feels routine.
Understanding taxes on index funds
This is the part beginners don’t expect: you owe taxes on an index fund even if you don’t sell.
Index funds distribute dividends (payments from the companies in the fund) and capital gains (profits from the fund’s internal rebalancing) at least once a year. Even if you reinvest those distributions automatically, the IRS considers them taxable income.
In a taxable brokerage account:
- Qualified dividends are taxed at long-term capital gains rates (0%, 15%, or 20% depending on your income).
- Non-qualified dividends are taxed as ordinary income (your marginal tax rate).
- Short-term capital gains distributions are taxed as ordinary income; long-term distributions at the lower capital gains rate.
According to IRS Publication 550, you report these distributions on your tax return whether or not you reinvested them. Your brokerage sends you a 1099-DIV with the amounts.
In a tax-advantaged account (IRA, 401(k), etc.):
- You owe no taxes on distributions while the money stays in the account. This is the main reason financial advisors recommend maxing out retirement accounts first.
Why index funds are more tax-efficient than active funds: Because index funds trade infrequently, they generate fewer capital gains distributions. Active funds that turn over 50–100% of their holdings annually trigger taxable events constantly. FINRA notes that high turnover can create unexpected tax bills even in losing years.
Tax-loss harvesting: If you own index funds in a taxable account and one drops in value, you can sell it at a loss, buy a similar (but not identical) fund, and use the loss to offset other gains or up to $3,000 of ordinary income per year. Some robo-advisors automate this. It’s one of the few tax strategies available to index investors without turning into active traders.
Tax laws vary by jurisdiction — this is U.S. federal tax treatment, and state taxes may differ. If you’re investing significant amounts in taxable accounts, a tax professional can save you more than they cost.
Rebalancing: the second hidden cost
Here’s a mistake I made in year two: I bought a total stock index fund and a bond index fund in a 70/30 split, then ignored it for three years. When I checked, the ratio had drifted to 82/18 because stocks had outperformed bonds. I was taking more risk than I’d planned, and I didn’t realize it.
Rebalancing means selling some of what’s grown and buying more of what’s lagged to get back to your target allocation. Most guidance suggests rebalancing once a year, or whenever an asset class drifts more than 5 percentage points from its target.
This isn’t about the fund rebalancing itself — index funds do that automatically when the index changes. This is about your portfolio of multiple funds drifting over time.
The Bogleheads three-fund portfolio approach — U.S. stocks, international stocks, and bonds — is popular because it’s simple to rebalance. You check once a year, compare your percentages to your target, and adjust.
Rebalancing has a hidden cost: it can trigger taxable capital gains in a taxable account. In retirement accounts, you can rebalance freely without tax consequences. In taxable accounts, some investors wait until they have new money to invest, then direct it toward the lagging asset class instead of selling winners.
Rebalancing also costs you in opportunity cost if the winning asset keeps winning. In the 2010s, U.S. stocks outperformed international stocks for a decade. Investors who rebalanced annually sold some U.S. exposure every year to buy more international, which hurt returns. But it also kept their risk in check, which is the point.
There’s no perfect answer. Rebalancing enforces discipline — it makes you buy low and sell high by design — but it’s not free.
What it means for someone considering index funds
Index funds are not risk-free. They are not guaranteed. When the market falls, your index fund falls with it. In 2008, the S&P 500 dropped 57% from peak to trough. In March 2020, it fell 34% in a month. If you had an S&P 500 index fund during those periods, your account balance dropped by the same percentage.
Diversification within the fund (owning 500 companies instead of one) reduces company-specific risk. It does not reduce market risk. If the entire market declines, your fund declines.
You need to be able to tolerate watching your account balance drop by 20%, 30%, or more without panicking and selling. That’s harder than it sounds. I’ve done it twice — 2018 and 2020 — and both times I had to remind myself that selling locks in the loss. I held, and both times the account recovered within a year. That’s not a guarantee it will happen again. It’s just what happened.
What to look for when comparing index funds
I’m not recommending specific funds, because that’s not what I do. But I can tell you what experienced investors look for when they compare:
Low expense ratios. Anything under 0.10% is excellent. Anything over 0.50% for a plain index fund is high.
Broad market exposure. Total market funds (which track thousands of companies, not just 500) give you more diversification than large-cap-only funds. Some investors prefer this; others are fine with an S&P 500 fund. Both are valid.
Platform accessibility. Some funds require $3,000 or $10,000 minimums; others have no minimum if you buy through the right brokerage. If you’re starting with $100, look for platforms that allow fractional shares or have $0 minimums. We cover this in How to Start Investing with $100: A Beginner’s Guide.
Tax efficiency. ETF versions of index funds are often slightly more tax-efficient than mutual fund versions due to how they handle redemptions. For taxable accounts, this can matter. For retirement accounts, it doesn’t.
FAQ
What is the difference between an index fund and a stock?
A stock is ownership in one company. An index fund is ownership in a basket of companies — often hundreds or thousands. When you buy a stock, you’re betting on that one company’s success. When you buy an index fund, you’re buying the average performance of the entire market (or sector) the fund tracks.
Can you lose money in an index fund?
Yes. Index funds go down when the market goes down. There is no principal protection. If you invest $10,000 and the market drops 20%, your balance drops to $8,000. Over long periods, markets have historically recovered and grown, but past performance doesn’t guarantee future results.
Are index funds better than individual stocks?
Not universally, but for most beginners, yes. Picking individual stocks requires research, discipline, and comfort with concentration risk. Index funds give you instant diversification and eliminate the risk of a single company going to zero. That said, some investors prefer the control and potential upside of individual stock ownership. It depends on your goals and risk tolerance.
How often should you invest in index funds?
Many investors use dollar-cost averaging — investing a fixed amount on a regular schedule (monthly, biweekly) regardless of market conditions. This spreads out your entry points and removes the pressure to time the market. Some platforms automate this. Both approaches work; consistency matters more than timing.
Do I owe taxes if I don’t sell my index fund?
Yes, if you hold the fund in a taxable account. The fund distributes dividends and capital gains annually, and you owe taxes on those even if you reinvest them. In a retirement account (IRA, 401(k)), you don’t owe taxes until you withdraw the money.
About the author
Quinn Sutherland writes the investing and trading content for FinovaDaily. They started investing in 2018 with $200 and have been adding monthly ever since — including through two market drops that tested their resolve. They explain what things are and what can go wrong, but they don’t tell you what to buy.
This is not financial advice, and tax laws vary by jurisdiction. Past performance does not guarantee future results. Consult a tax professional or financial advisor before making investment decisions.