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What Is an Index Fund?

What Is an Index Fund?

February 14, 2022
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In the past, we've covered a number of topics related to different types of investments. We've talked about stocks, bonds and mutual funds. We've covered risk tolerance and how to find the appropriate investment for you. We've talked about exchange traded funds and how they differ from mutual funds.

But in looking back through our library of blog posts, YouTube videos and more, I realized that we haven't covered one of the most basic types of investments there is: the index fund.

So let's make up for lost time and cover what this tool is, why it's so popular, and whether or not it's a fit for your investment style.


An index, or a market index, is a collection of companies that represent a specific segment of the market. There are indices that represent US companies of a certain size. There are indices that represent the entire bond market or stock market. There are even indices that represent publicly traded companies from specific foreign countries. You name a segment of the market, and there is likely an index that tracks it.

An index fund is either a mutual fund or exchange traded fund set up to mirror the returns of a market index. Rather than paying a team of investment managers to make decisions on when to buy and sell, and index fund seeks to simply mimic the returns of its benchmark index.

Index investing is a form of passive investing, and many consumers like them because of their simplicity and low cost.

Since you're not paying for as much human oversight, the fees associated with index funds are typically much lower than what you find in an actively managed fund. And since many indices include companies based on certain performance metrics, such as the amount of cash they have or the price for a share of their stock, investing in a certain index can ensure that your money is always tracking the return of the highest performing companies in a particular market segment. This characteristic prevents you from having to make investment decisions you may not have the knowledge to make. Instead, the rules of the index will decide which companies stay or go.

If you follow any of our content, you're well-aware that I hate it when people speak in absolutes when it comes to anything finance-related. And there are those who say that index investing is the ONLY way to invest, no matter what. I am a fan of index funds, but I won't take it that far. But before I add in my own opinions, let's cover the facts regarding index funds.


While the S&P 500 is the most well-known index, it does only represent one portion of the market. The S&P 500 tracks the movements of 500 large, publicly traded US companies. There are, however, several other indices that track different portions of the market:

  • S&P 500: 500 large, publicly traded US stocks
  • Dow Jones: 30 large cap, “blue chip” stocks 

  • Bloomberg US Aggregate Bond Index: total bond market 

  • MSCI EAFE: international stocks from Asia, Australia, Europe 

  • Nasdaq: 3,000+ stocks, REITS, ADRs 

  • Wilshire 5000: 7,500+ US stocks 

Choosing the index or indices that are appropriate for your portfolio all boils down to the portions of the market to which you would like exposure. If you want your portfolio to invest in international holdings, the S&P 500 doesn't fit the bill; you would need exposure to the MSCI EAFE index. If you're worried about stocks and want to include some bonds in your investments, contributing to a Bloomberg US aggregate Bond Index fund would be appropriate.

When choosing an index, it's also important to know how it is weighted. Indices don't simply take money and spread it out evenly based on the number of companies in an index. Instead, they weight their holdings, and some companies will have a larger impact on the movement of the index than others because they are weighted more heavily.

The two most common ways in index can be weighted are by market capitalization or price.

Price is simply the share price of a company's stock. A price -weighted index is one where companies with a higher share price are weighted more heavily than ones with a lower share price.

Market capitalization is the value of a publicly traded companies outstanding shares of stock. As an example, if a company's share price is $20 per share and there are 1 billion outstanding shares, their "market cap" is $20 billion. This tool serves as a way to measure just how large a company is, and there are categories for these companies based on market as well. Large cap are those with a market cap of $10 billion or more. Mid-cap companies have a market capitalization between $2 billion and $10 billion, and small-cap companies hold market capitalizations under $2 billion.

Since having more money on hand typically implies that a company is well established and on firm footing, companies with larger market caps are seen as more stable places for consumers to invest. Thus, an index weighted by market capitalization is one where companies with the most cash on hand are weighted more heavily in the index.

Now that you understand the terminology, let's look at those same indices to see how they are weighted:

  • S&P 500: 500 large, publicly traded US stocks (Market Cap)

  • Dow Jones: 30 large cap, “blue chip” stocks (Price)

  • Bloomberg US Aggregate Bond Index: total bond market (Market Cap)

  • MSCI EAFE: international stocks from Asia, Australia, Europe (Market Cap)

  • Nasdaq: 3,000+ stocks, REITS, ADRs (Market Cap)

  • Wilshire 5000: 7,500+ US stocks (Market Cap)

Adding the knowledge of how an index is weighted to what you already know about the companies in which it invests can be helpful. Since the S&P 500 primarily focuses on a company's size in terms of cash, an investor looking for exposure to smaller companies with growth potential could look to a broader index or even one that is price-weighted. Conversely, an investor who wants to ensure their portfolio only holds large, stable companies might avoid the Dow Jones, because market capitalization isn't a factor in its weighting.


Absolutely. In the mutual fund world, there are what's called Fund of Funds (FOF). For lack of a better description, fund of funds pool together multiple mutual funds or ETFs to form a larger, super portfolio. You could have a fund of funds that is comprised of four or five other investment funds, with different percentages allocated to each underlying fund in a manner that meets undetermined objective or risk tolerance.

Let's look at an example:

Here we have a fund that comprises four other index funds. Twenty percent is invested in an MSCI EAFI index fund, giving our investor some international exposure. The S&P 500 fund represents 40% of its holdings, giving our investor access to some of the largest (and hopefully stable) companies in the US stock market. And 20% each are in funds that track the Dow Jones - blue chip stocks with high share prices - and the Bloomberg US Aggregate Bond Index.

While there are four indices represented, this fund is essentially 80% stocks and 20% bonds, making it pretty aggressive. An aggressive investor who wants to keep their costs low but also have access to a broader swath of the market could consider this fund of funds, rather than trying to figure out how much of each index to invest in on their own.


This might sound odd to hear from an investment advisor, but in the long run I feel that the market will always beat a human being making decisions on how to invest. If you had $100,000 and invested half your money in a mutual fund actively managed by a team of human beings for 50 years, and the other half in an index fund with a similar objective for the same length of time, the index fund will outperform in most scenarios. In fact, in 2007 Warren Buffett bet $1 million that an index fund would outperform an actively managed fund (and he won the bet). And if your only objective is to have the most money at the end of a period of time, regardless of what happens in between, investing in indices might be all you need to do. After all, it carries lower costs and you don't have to make any investment decisions; it's all done for you.

The problem is that for many people, it isn't as simple as just having the largest amount of money after 40 or 50 years. Life happens, and they might need access to that money unexpectedly in 10 or 15 years. Maybe they plan to retire early, or they decide they want to help their children pay for college. More importantly, maybe their risk tolerance isn't a good match for the volatility you can find in some of the more popular index funds.

There are plenty of scenarios where an index might not meet the needs and goals of a household. If you're an investor hoping to accumulate investments that generate dividends on which you can live, investing in a broad index might be less appropriate than a handful of blue-chip stocks with a strong history of dividend payments to shareholders. If you've invested a pool of money that you will need to access within five years - maybe to make a down payment on a home or to buy a new car - placing that money in a broad index with over 7,500 stocks might lead to far more volatility than is appropriate for those specific funds.

The point when picking any investment is to make sure you have a full understanding of your needs, your risk tolerance and your expectations. If an index fund checks all the boxes, that's great, but you never want to assume it does simply because you've heard other people say it's the only way to invest.