What Is an Index Fund?

How it works

An index fund is a mutual fund, ETF, or similar investment that follows a passive strategy: it aims to achieve roughly the same return as a particular index, before fees.¹ Instead of a manager choosing stocks, the fund holds what the index holds, in the same proportions.

Why costs matter so much

The economist William Sharpe pointed out a simple piece of logic. Before costs, the average dollar invested by active managers must earn the same return as the average dollar invested passively, because together they own the whole market. After costs, the average actively managed dollar must earn less, because active management costs more.² Small differences in cost compound over time.

Yearly fee	Return after fees	Value after 30 years
0.05%	6.95%	About $75,100
1.00%	6.00%	About $57,400

The same investments, with a one-point difference in cost, end about $17,700 apart.

What an index fund can't do

It holds the market, so it falls with the market. It won't avoid a bear market or a bubble in the stocks it tracks. And not every index fund is cheap: costs vary, so the expense ratio still needs checking.¹