What Is an Index, and Why Do Funds Follow It?

Short answer: An index is a rule based list that measures a part of the market. A fund follows it by buying the investments on that list, in similar proportions, so it aims to match the list, before fees, instead of trying to beat it. Funds follow indexes because that approach is simple, spreads money across many investments at once, and usually costs less than paying a team to pick winners.

Think of an index as a measuring stick, not a product you can buy. You cannot buy the S&P 500 list itself, but you can buy a fund that copies it. That distinction matters, because two funds can both be called index funds yet track very different lists, with very different risks.

What is an index, in simple terms?

An index is a list with rules. The rules say which investments are included, how much weight each one gets, and when the list changes. The list is then used to measure how that part of the market performs.

A broad market index may include hundreds or thousands of companies. A narrow index may include only one industry, one country, or large companies only. A bond index may include government or company bonds, instead of stocks.

Common examples help. The S&P 500, maintained by S&P Global, is a list of 500 large United States companies. The Dow Jones Industrial Average is a list of 30 large United States companies, weighted in a different way. A total market index aims to cover almost the whole stock market in one country, not just the largest companies. A world index aims to cover many countries at once.

Indexes are not only for stocks. There are indexes for bonds, for property companies, for commodities, and for many other slices of the market. The idea is always the same: define a slice, set clear rules for what belongs in it, and track how that slice performs over time.

Why do indexes exist at all?

Indexes measure a part of the market, so news reports that the market rose or fell have a clear meaning. They also give a public benchmark to compare a fund against, and once a list is defined, a fund can copy it instead of guessing which companies will do best next.

How does a fund follow an index, step by step?

Step 1: The index provider publishes the list and the weights. In a market value weighted index, larger companies get a larger weight. In an equal weighted index, each company gets a similar weight. Most broad indexes beginners meet are market value weighted, but always check, because weighting changes risk.

Step 2: The fund buys the investments in that index, or a representative sample, in similar proportions. Investor.gov describes an index fund as following a passive strategy designed to achieve approximately the same return as its index, before fees.

Step 3: The fund stays close to the index. The manager is not trying to guess which company will do best next month. The job is to keep the fund in line with the list, and to adjust it when the index changes, for example when a company is added, removed, or grows larger.

Step 4: You buy shares of the fund, not shares of each company one by one. Your money is pooled with other investors to buy the basket. One purchase can therefore give you a small piece of hundreds of companies, instead of a large piece of one company.

Passive is the key word. Active management means a manager tries to beat the market by choosing investments. Passive management means the fund tries to match the market it tracks. Passive funds usually trade less, which the SEC guide links to lower transaction costs, more favorable tax consequences in some cases, and lower fees than actively managed funds.

Why do funds follow indexes? Four practical reasons

First, diversification in one purchase. Diversification means spreading money across many investments, so one company doing badly does not decide your whole result. A broad index fund can hold hundreds of companies across many industries, while a single stock rises and falls with one company. That does not make a broad fund safe, because market risk remains, but it does reduce company specific risk. Our guide to diversification explains this in simple terms. See: What Is Diversification, and Why Does It Matter?

Second, simplicity. You do not need to research dozens of companies or decide when to sell each holding. You choose a broad index you can explain in one sentence, a fund that tracks it, and a regular amount that fits your budget, then review it from time to time. Our earlier guide to index funds covers the beginner case in full. See: What Is an Index Fund, and Why Do Beginners Use It?

Third, lower cost, in general. With no team of stock pickers to pay, index funds often charge less than actively managed funds. The SEC guide states that, over time, higher fees and expenses can significantly lower investment returns. Small yearly fees matter because they are charged year after year. Fees are covered in detail in our guide to investing fees. See: What Are Fees in Investing, and How Do They Hurt Returns?

Fourth, a clear benchmark and a hard test for active managers. Because an index is public and rule based, anyone can check whether an active fund actually beat it, after fees, over a long period. S&P Global, through its SPIVA scorecard, reported that 88 percent of United States large cap active managers underperformed the S&P 500 over the 10 years ending in 2023, and 92 percent underperformed over 15 years to the same date. That is a historical result for that period, not a promise about the future, and not a claim that every index fund beats every active fund. It does explain why many beginners ask: if most professionals struggle to beat the list, why pay extra to try?

Worked example 1: how weighting works

Weighting decides how much of your money goes to each company, and it is easy to miss.

Suppose a fund tracks an index with only two companies, for illustration. Company A has 80 percent weight, and Company B has 20 percent weight. You invest 10,000 in the fund.

Amount in Company A: 10,000 times 0.80 equals 8,000.

Amount in Company B: 10,000 times 0.20 equals 2,000.

Now suppose Company A falls by 10 percent, and Company B rises by 10 percent.

Company A holding: 8,000 times 0.90 equals 7,200, a fall of 800.

Company B holding: 2,000 times 1.10 equals 2,200, a rise of 200.

Total: 7,200 plus 2,200 equals 9,400, a fall of 600 from 10,000.

The fund fell, even though one company rose, because the larger company carried more weight. In a real broad index, the largest companies can take up a large share of the fund, so check the top holdings and how much weight they carry. A broad name does not always mean an even spread.

Worked example 2: one company versus a basket

This example uses made up numbers, not a prediction of any real return. Imagine you have 6,000 to invest.

Choice A, one stock: you put the full 6,000 into one company. If it falls by 50 percent, your holding becomes 3,000, because 6,000 times 0.50 equals 3,000 lost.

Choice B, a broad basket of 60 companies, with your 6,000 spread evenly for this illustration: each company gets 100, because 6,000 divided by 60 equals 100. If one company falls by 50 percent, that holding falls from 100 to 50, a loss of 50. If the others stay the same in this simplified example, your total becomes 5,950, because 6,000 minus 50 equals 5,950. The same fall now costs you 50, not 3,000.

This example is simplified. In real life, many companies move at once, and a market fall can pull most holdings down together. A basket spreads company specific risk, but it does not protect you from a market wide fall.

Worked example 3: tracking, fees, and a small gap

Suppose an index rises by 8 percent in a year. A fund tracking it aims to rise by about 8 percent, before fees.

On 10,000, an 8 percent rise before fees is 10,000 times 1.08, which equals 10,800.

If the fund charges 0.05 percent per year, the yearly fee on 10,000 is 10,000 times 0.0005, which equals 5.

A simplified balance after that fee is 10,800 minus 5, which equals 10,795.

A different fund charging 1 percent per year would cost 10,000 times 0.01, which equals 100. The difference is 100 minus 5, which equals 95 per year, on the same 10,000, before any other costs. Over many years, that difference adds up, and money paid in fees cannot grow in your account.

A small gap is normal, from fees, trading costs, and sampling. A large or growing gap is worth questioning.

Index fund, ETF, and index: do not mix up the words

An index is a list and a measurement. You cannot buy it directly. An index fund is a fund that follows an index, and it can be a mutual fund, an exchange traded fund, or a unit investment trust. Index describes the strategy. An ETF is a fund that trades on a stock exchange during the day, like a stock. ETF describes how it trades, not its strategy. An index ETF is both. So ask two questions: what index, if any, does it follow, and how does it trade?

What are the risks and limits of following an index?

An index fund is not risk free, and four limits deserve honest attention.

First, market risk: a broad index fund falls when the market falls, and money needed soon usually fits better in saving. See: How Do I Build an Emergency Fund From Zero?

Second, concentration: in a market value weighted index, the largest companies can take up a large share, so check top holdings.

Third, tracking difference: fees, trading costs, and sampling can create a small gap. A large or growing gap is worth questioning.

Fourth, the wrong index: a narrow industry fund is less diversified than a broad fund, and a foreign index may carry currency risk and different tax rules. Always ask which index it is, what it contains, and whether it fits your goal.

No index fund removes the need for an emergency fund, a budget, and a debt plan, and no index fund guarantees a return.

How to read an index fund, in 5 steps

Step 1: Name the index in one sentence. For example: this fund tracks 500 large United States companies, weighted by market value. If you cannot explain the index in one sentence, do not buy it yet.

Step 2: Check what is inside: the number of holdings, the top holdings, the industries covered, and the countries covered. A broad fund should look broad.

Step 3: Check the total cost, not only the expense ratio. Look for the expense ratio, the index tracked, the number of holdings, and any extra account charges, trading costs, or currency conversion fees.

Step 4: Check how closely it tracks its index. Look for tracking difference in the fund documents, and ask whether the gap is small and stable, or large and growing.

Step 5: Decide how you will invest, and how often you will review it, for example a fixed amount on a regular schedule, reviewed once or twice a year.

Do not choose a fund only because its index rose a lot last year. Choose on the index, the cost, the holdings, and whether the risk fits the time you have before you need the money.

Common mistakes to avoid

• Buying an index directly, which is not possible, or buying a fund without checking which index it tracks.
• Thinking index means safe. Index describes a strategy, not a risk level. A narrow index can be risky, and a broad index still falls when the market falls.
• Buying many overlapping index funds, thinking that is more diversification, when it is duplication.
• Chasing a hot sector index fund as if it were a broad fund. A sector fund can rise fast and fall fast, because it is concentrated in one industry.
• Selling after a market fall out of panic. Sell because your plan or goal changed, not because of one bad week.
• Ignoring fees. A similar fund charging much more each year will leave you with less over time, even if it tracks the same index.
• Investing money you need soon. Money for rent, bills, or an emergency fund does not belong in a market fund, because the market can fall at any time.

Frequently asked questions

What is an index, in one sentence?

An index is a rule based list that measures a part of the market, such as 500 large United States companies, or the whole stock market in one country.

Can I buy an index?

No, not directly. An index is a measurement, not a product. You buy a fund that copies the index, such as an index mutual fund or an index ETF.

Not exactly. Index describes a strategy, following a list. ETF describes how a fund trades, on an exchange during the day. An index ETF is both, but an index fund can also be a mutual fund, and an ETF can be actively managed.

Why do funds follow indexes instead of picking winners?

Because picking winners is hard, even for professionals, because it usually costs more, and because a rule based list gives a clear, public benchmark to judge results against. Following an index does not guarantee a better result, but it is simple, diversified, and usually low cost.

Can I lose money in an index fund?

Yes, especially when the whole market falls. Diversification reduces company specific risk, but it does not remove market risk, and it does not guarantee a profit. Our guide to risk explains the types of risk in plain language. See: What Is Risk in Investing, in Simple Terms?

Conclusion and first step today

An index is a simple idea with a big effect: define a market list by clear rules, measure it, and let a fund copy it at low cost, instead of betting on one company or paying a team to guess.

Your first step today is not to buy anything. Answer three questions on paper: which index would I track, and can I explain it in one sentence? What is the total yearly cost? How long can I leave this money invested? If you cannot answer them yet, you have a clear reading list, not a reason to rush.

This article is for general information and education only. It is not financial advice.