How Do Index Funds Actually Work?

You have probably heard someone say "just buy index funds" like it is the most obvious financial advice on the planet. And honestly, it kind of is. But nobody ever stops to explain what is actually happening when you buy one.

Let's fix that.

What even is an index?

An index is just a list of companies grouped together to represent a chunk of the market. The S&P 500 is the most famous one — it tracks 500 of the largest publicly traded companies in the U.S. Think Apple, Microsoft, Amazon, JPMorgan, and about 496 others.

Nobody "created" the S&P 500 as an investment. It started as a measuring stick. Financial analysts wanted a way to answer the question: "How is the overall stock market doing today?" So they built a list and tracked its average performance.

The genius move came later: what if you could just buy that entire list?

How does an index fund actually track the index?

An index fund is a real investment product — either a mutual fund or an ETF — that buys all (or nearly all) of the stocks in a specific index, in the same proportions.

So when you buy a single share of an S&P 500 index fund, your money gets spread across all 500 companies automatically. You are instantly diversified across the biggest companies in America with one purchase.

There is no manager picking stocks or making gut calls. The fund just mirrors the list. If a company gets added to the S&P 500, the fund buys it. If one gets removed, the fund sells it. That is the whole strategy.

If you are just getting started with investing, this pairs well with understanding the basics of investing in your 20s.

Why do index funds beat most actively managed funds?

This is the part that surprises people. Over a 20-year period, roughly 90% of actively managed funds underperform the S&P 500. Professional stock pickers, with teams of analysts and Bloomberg terminals, lose to the boring index fund.

Why? A few reasons:

Fees eat returns. Active funds charge higher fees for all that research and trading, which drags down your net performance year after year
Consistency is hard. A manager might beat the market one year and underperform the next three. The index just keeps compounding
Markets are efficient. Most publicly available information is already priced into stocks, making it extremely difficult to find consistent edges

What are expense ratios and why should you care?

The expense ratio is the annual fee a fund charges you, expressed as a percentage of your investment. It gets deducted automatically — you never see a bill.

Here is why it matters. A typical actively managed fund charges around 0.50% to 1.00% per year. A solid S&P 500 index fund charges around 0.03% to 0.10%.

That difference sounds tiny until you do the math. On a $100,000 portfolio over 30 years, the difference between a 0.03% fee and a 0.75% fee is over $150,000 in lost gains. That is not a rounding error. Low fees are one of the single biggest advantages you can give your future self.

ETF vs. mutual fund — what is the difference?

Index funds come in two wrappers:

ETFs (Exchange-Traded Funds) trade on the stock exchange like a regular stock. You can buy and sell them throughout the day at the current market price. Most have no minimum investment beyond the price of one share
Mutual funds are priced once per day after the market closes. Some have minimum investments (like $1,000 or $3,000), but many brokerages now offer $0 minimums

For most people in their 20s, ETFs are the easier starting point. Lower minimums, no special account requirements, and you can buy fractional shares at most brokerages.

How do you actually buy one?

The process is simpler than you think:

Open a brokerage account (Fidelity, Schwab, or Vanguard are solid choices)
Search for an S&P 500 index fund — popular tickers include VOO, FXAIX, or SPLG
Decide how much you want to invest
Place the order

That is literally it. If you want to start with a small amount, here's how to begin investing with $100 or less. If you are deciding where to hold your index funds — like a Roth IRA vs. a traditional IRA — that is a separate but important decision. Check out our breakdown of Roth vs. Traditional IRAs or our full guide to tax-advantaged accounts to figure out which account makes sense for you.

The bottom line

Index funds are not exciting. There is no thrill of picking the next big winner. But they are the single most reliable wealth-building tool available to everyday investors. Low fees, instant diversification, and a track record that embarrasses most professionals.

The hardest part is not choosing which fund to buy. It is starting.

Ready to build on this? Check out our step-by-step guides to put your money to work.