Glossary
Index fund
A mutual fund or ETF that aims to match the return of a market index by holding its constituents, usually at low cost.
On this page
An index fund is a mutual fund or ETF designed to replicate the performance of a market index rather than to beat it. Instead of a manager picking stocks, the fund holds the index's members in roughly the same proportions, buying and selling only when the index changes. Because there is little research to pay for and little trading, index funds are typically among the cheapest ways to own a diversified portfolio, and they have become the core holding for many long-term investors.
How it works
The fund either holds every security in the index (full replication) or, for very broad or illiquid indexes, a representative sample. Two measures tell you how well it does its job:
- Tracking difference: how far the fund's return lagged or beat the index over a period, mostly reflecting fees.
- Tracking error: how much that gap varies from period to period.
History and debate
Vanguard launched the first index mutual fund for individual investors in 1976, tracking the S&P 500. Since then, studies such as S&P Dow Jones Indices' SPIVA reports have repeatedly found that most active US stock funds underperform their benchmarks over long periods after costs, which helped index investing grow. Critics note that index funds buy whatever the index contains, including expensive stocks, and that concentration in the largest companies can rise. An index fund also delivers the market's losses in full; it removes the risk of picking the wrong manager, not market risk.