What Is an Index Fund?

If someone told you there was an investment that beat 90% of professional money managers over any 20-year period, charged almost nothing in fees, required zero effort, and was endorsed by Warren Buffett — you'd think it was too good to be true. It's not. It's an index fund, and it might be the single greatest invention in the history of personal finance.

How It Works

An index fund is a type of mutual fund or ETF that tries to match the performance of a specific market index by holding all (or a representative sample) of the securities in that index. Instead of paying a fund manager to pick stocks, the fund simply buys everything in the index and holds it.

The most popular index in the world is the S&P 500, which tracks the 500 largest publicly traded companies in the United States. When you buy an S&P 500 index fund, you instantly own a piece of Apple, Microsoft, Amazon, Google, Johnson & Johnson, JPMorgan, and about 493 other companies. One purchase, 500 companies, total diversification.

Other popular indexes include the Total Stock Market Index (the entire U.S. market — about 4,000 stocks), the MSCI EAFE (international developed markets), and the Bloomberg Aggregate Bond Index (the U.S. bond market).

The concept was pioneered by John Bogle, who founded Vanguard in 1975 and launched the first index fund available to individual investors. Wall Street laughed at him. They called it "Bogle's Folly." Today, index funds hold over $11 trillion in assets and Vanguard is the largest investment company in the world.

The key advantage is cost. Because an index fund doesn't need expensive analysts, researchers, or star portfolio managers, it charges a fraction of what active funds charge. Vanguard's S&P 500 fund (VFIAX) charges just 0.04% per year — that's $4 per $10,000 invested. The average actively managed fund charges 0.66% or more.

Why It Matters for Investors

The data on index funds vs. active management is devastating — for active managers. According to the SPIVA Scorecard, over a 20-year period ending in 2023, 95% of large-cap actively managed funds underperformed the S&P 500. Not 50%. Not 70%. Ninety-five percent.

Why? Fees. The average active fund charges 0.5-1.0% more per year than an index fund. Over decades, that fee drag compounds into a massive drag on returns. An active manager needs to beat the market by their fee just to match an index fund — and most can't do it consistently.

Warren Buffett is the most famous advocate of index funds for individual investors. In his 2013 letter to Berkshire Hathaway shareholders, he wrote that his estate instructions were to put 90% of his wife's inheritance in an S&P 500 index fund and 10% in short-term government bonds. When the greatest investor of all time tells you to buy an index fund, you should probably listen.

Real Example

Let's compare a real index fund versus the average active fund over 30 years with a $10,000 initial investment and $500 monthly contributions:

Vanguard S&P 500 Index Fund (0.04% expense ratio): Assuming a 10% gross market return, after fees your net return is about 9.96%. After 30 years: approximately $1,127,000.

Average actively managed large-cap fund (0.66% expense ratio): Same gross return, but after fees your net return is 9.34%. After 30 years: approximately $1,012,000.

High-cost active fund (1.2% expense ratio): Net return drops to 8.8%. After 30 years: approximately $922,000.

The difference between the index fund and the high-cost active fund is about $205,000 — on the same underlying investment. And remember, this assumes the active fund matches the market before fees. Since 95% of them don't, the real gap is even wider.

John Bogle estimated that over a lifetime, unnecessary investment fees cost the average American family between $300,000 and $600,000 in lost wealth. Index funds are the antidote.