If you’ve heard that most professional fund managers underperform simple index funds over time, that’s largely true. Here’s what index funds and ETFs are, how they differ, and why so many investors rely on them.
What is an index fund?
An index fund is a type of investment fund that tracks a market index — a benchmark like the S&P 500, which represents 500 of the largest U.S. companies. Instead of a manager picking which stocks to buy or sell, the fund simply holds what the index holds, in the same proportions.
Your returns closely match whatever the index returns. If the S&P 500 rises 10%, an S&P 500 index fund rises roughly 10% (minus a small fee). If it falls 15%, you’re down roughly 15% too.
What is an ETF?
An ETF — exchange-traded fund — is similar to an index fund in that it typically tracks a market index. The main difference is how it trades: ETFs are bought and sold on stock exchanges throughout the day, just like individual stocks. Index funds generally trade once per day at a fixed price after the market closes.
For most long-term investors, the practical difference is minor. Both give you low-cost, diversified exposure to a market or sector.
Why are fees so much lower?
Because there’s no manager making active decisions, index funds and ETFs have much lower operating costs than actively managed funds. These costs are expressed as an expense ratio — an annual percentage of your investment.
A typical actively managed fund might charge 0.5–1% per year. Many index funds charge 0.03–0.10%. On a $100,000 portfolio, that difference compounds dramatically over decades.
What do they own?
A broad market index fund tracking the S&P 500 owns small pieces of hundreds of companies across many industries — technology, healthcare, financials, consumer goods, and more. That built-in diversification means no single company’s bad year can devastate your portfolio.
You can also find index funds and ETFs that track international stocks, bonds, real estate investment trusts (REITs), or specific sectors like healthcare or energy.
How do they compare to actively managed mutual funds?
Mutual funds managed by professionals make active decisions about what to buy and sell, trying to beat the market. Some do, in some years. But over long periods, the majority of actively managed funds underperform their benchmark index, primarily because fees eat into returns.
That’s not to say mutual funds have no place — some people prefer professional management, especially in less efficient markets. But for most investors building retirement savings, low-cost index funds are a practical core choice.
Where to find them
Most 401(k) plans include at least some index fund options — look for the lowest expense ratios when choosing. In an IRA at a brokerage, you’ll generally have access to a wide range of ETFs and index funds with minimal minimums.
Further Reading
- What Is an Index Fund? Understanding the Basics
- The Benefits of Index Funds
- What Is an ETF? Understanding the Basics
- Investing in ETFs: Exchange Traded Funds
- What Is a Mutual Fund? Understanding the Basics
- What Is Diversification? A Beginner’s Guide
This article is for general educational purposes only and does not constitute financial or investment advice. Consult a qualified financial advisor before making investment decisions.