Index funds explained: what they are and how they work

What an index fund is, how it tracks an index, why it costs less than an active fund, and what decades of data say about active funds.

Part of the Investing Foundations track on Agenticks. About 10 minutes, written for a beginner reader.

Read first: What is an index (S&P 500, Nasdaq, Dow explained).

Last reviewed .

Key takeaways

An index fund is a fund that tries to copy an index instead of trying to beat it. If you have read what an index is, you already have the idea: an index such as the S&P 500 or the S&P/TSX Composite is a scorecard for a chosen basket of companies. You cannot buy a scorecard. An index fund turns it into something you can own by buying the companies in the index, in roughly the same proportions, so the fund's value moves with the index, minus a small cost. Index funds come in two main wrappers. Some are mutual funds, priced once a day after the market closes. Others are exchange-traded funds, or ETFs, which trade on an exchange through the day like a share. The copying works the same way in both. The ETFs and funds vs stocks lesson covers how the wrappers differ.

Most broad indexes weight each company by its total market value, so the biggest companies take up the biggest share of the index. An index fund follows those weights exactly. A small made-up index shows what that does to $1,000.

Worked example: where $1,000 in an index fund goes

A made-up index holds four companies worth $1,000 billion in total. Each weight is a company's value divided by that total.

Company A, worth $600 billion (60%) (1,000 x 0.60)$600
Company B, worth $250 billion (25%) (1,000 x 0.25)$250
Company C, worth $100 billion (10%) (1,000 x 0.10)$100
Company D, worth $50 billion (5%) (1,000 x 0.05)$50
Company A rises 10%, the rest stay flat (600 x 1.10)$600 becomes $660
Fund value, and the index, after the move$1,060 (+6%)

Illustrative numbers, not real companies. Fees are left out here and covered below.

Two things follow from that example. First, nobody at the fund decided whether Company A was a good buy. The index rules set the weights and the fund copied them. Second, the largest companies drive the result. A 10% move in the 60% holding moved the whole fund 6%, while the same move in Company D would have moved it half a percent. In real cap-weighted indexes a handful of giants can make up a large slice of the total, so owning the market can still mean leaning heavily on a few names.

Following an index this way is called passive investing. The alternative is active management: a manager researches companies, buys the ones they expect to do well, and aims to beat a benchmark, which is the index the fund is judged against. The first difference you notice is cost. Every fund charges a yearly running cost called its expense ratio, a percentage of your money that is taken out of the fund's assets, so you see a slightly lower return rather than a bill. Index funds trade less and pay for less research, which usually means lower trading costs, fewer taxable gains handed to investors, and lower fees than active funds. On $10,000, an expense ratio of 0.05% costs $5 a year and one of 1% costs $100 a year. That gap comes back every year and compounds, which the investment fees lesson works through with a calculator.

An active fund has to beat the index by more than its extra cost

If an index fund costs 0.05% and an active fund costs 1%, the active manager starts each year almost a full percentage point behind. Picking better stocks than the index is not enough. They have to pick enough better stocks to cover that gap, every year, before you are any better off.

Paying more would be fine if active managers reliably earned it back. The longest-running public test of that is the SPIVA scorecard from S&P Dow Jones Indices, which compares actively managed funds with the right benchmark for their category and counts how many fell short. In the US report for the end of 2025, about 86% of active large-company US stock funds trailed the S&P 500 over 10 years, about 90% over 15 years and about 93% over 20 years. The Canadian report for the same date found that 98.8% of Canadian equity funds trailed the S&P/TSX Composite over 10 years. The scorecards also count funds that closed or merged along the way, which matters. Of the 760 US large-company funds that existed 20 years earlier, only about 35% were still running at the end of 2025, and a study that only looked at the survivors would flatter the active side. Two cautions keep this fair. Some active funds do beat their benchmark in any period, and some categories have better stretches than others: in the same US report, only 41% of small-company funds lagged their index over the single year of 2025. The hard part is knowing in advance which funds will be the winners. And all of this describes the past. Past results do not guarantee future results, for index funds or for anyone else.

People often weigh an index fund against buying a few individual stocks. The difference is mostly about diversification. One stock ties your result to one company, so a single bad event can do a lot of damage. An index fund spreads the same money across every company in the index, so one failure is a small dent rather than a hole. What you give up is the chance of beating the market: an index fund will always be roughly the market. The diversification lesson explains what that spreading can and cannot protect you from.

Two index funds can look alike and still differ in ways that matter. The index itself. A fund tracking a broad national or global index holds hundreds or thousands of companies. One tracking a single industry or a small market holds far fewer and behaves more like a concentrated bet. The index decides what you own; the fund only copies it. The cost. For two funds tracking the same index, the expense ratio is often the biggest lasting difference between them. How closely it tracks. Comparing a fund's return with its index over several years shows the gap. A small, steady shortfall of about the fee is normal. A large or erratic gap is worth understanding before anything else. The wrapper. A mutual fund trades once a day at its closing price. An ETF trades through the day and has a bid-ask spread like a share. None of this depends on a manager's track record, which is part of the appeal. What you are judging is a rule and a price.

What an index fund does not do

It never beats its index, and when the index falls 20% the fund falls about 20% too. It owns every company in the index, including ones that look overpriced. A cap-weighted index can lean heavily on its largest companies or sectors. A fund that tracks a narrow index, one industry or one small country, is passive without being diversified. And small gaps between the fund and its index, called tracking error, come mostly from fees.

Index fund (passive)
Holds what the index holds, in the same proportions, Usually charges a lower yearly fee, Trades mainly when the index itself changes
Actively managed fund
A manager picks the stocks they expect to do best, Aims to beat its benchmark, Results depend heavily on one team's decisions

You can explain what an index fund is

You know how an index fund copies its index, why it costs less than an active fund, what the long-run evidence shows, and what it gives up.

Check your understanding

What is an index fund trying to do?
Match the return of an index, before its small fee. That is the whole job. It copies the index's holdings so its value moves with the index.
In the worked example, Company D makes up 5% of the index. If D doubles in value and the other three do not move, roughly how much does the fund rise?
About 5%. A 100% gain on a 5% weight adds about 5% to the whole fund: 5% x 100% = 5%.
SPIVA found that about 90% of active US large-company funds trailed the S&P 500 over 15 years. What is the fairest reading of that?
Most active funds fell short, and spotting the few winners in advance is hard. Some funds did beat the index, but they were a small minority and were not easy to identify beforehand.
Two funds track the same index. One has a 0.05% expense ratio and the other 1%. On $10,000, what is the yearly cost of each?
$5 and $100. 0.05% of $10,000 is $5, and 1% of $10,000 is $100. The gap repeats every year.

Common questions

What is an index fund in simple terms?
An index fund is a fund that copies an index, such as the S&P 500 or the S&P/TSX Composite. It buys the same companies in roughly the same proportions, so its value rises and falls with the index, minus a small yearly fee.
Is an index fund better than buying individual stocks?
They solve different problems. One stock ties your result to one company, while an index fund spreads it across every company in the index. An index fund cannot beat its index, but it removes the risk of one company sinking your whole investment. Which fits depends on the person.
Do index funds beat actively managed funds?
Over long periods most active funds have trailed their benchmark. S&P's SPIVA year-end 2025 report found about 90% of active US large-company funds lagged the S&P 500 over 15 years. That describes the past and does not guarantee future results.

Terms defined in this lesson

Continue

Sources

Written and reviewed by the Agenticks Learn editorial team. How we write and check lessons.

Agenticks Learn is general education. It is not financial, investment, tax or legal advice, it does not take your situation into account, and nothing on it is a recommendation to buy, sell or hold any security or to open any account. Examples use illustrative numbers. Investing involves risk, including losing money you put in, and past performance does not predict future results. Tax rules and limits change; the official sources linked in each lesson are the final word.