Introduction

Index funds mirror the performance of benchmarks like the S&P 500 and other market indexes by mimicking their makeup. Index funds invest in the same assets using the same weights as the target index, typically stocks or bonds. Index funds provide broad market exposure and diversification across various sectors and asset classes.

These passive investments attract many investors. In 2021, passive index funds tracking market benchmarks accounted for just 21% of the U.S. equity fund market.

By 2023, passive index funds had grown to about half of all U.S. fund assets.

Here's how it works in practice:

• The index (like the S&P 500) periodically updates its list of companies and their weights based on market capitalization and other rules.
• The fund manager (or, more often, automated systems) regularly reviews the index and adjusts the fund's holdings to match any changes—such as when a company grows, shrinks, or is added/removed.
• This process is called "rebalancing." It can be done daily, monthly, or quarterly, depending on the fund.
• Most index funds use software and algorithms to automate these updates, so it's not all manual, but human oversight is still involved.

Conclusion

Index funds are a popular choice for investors seeking low-cost, diversified, and passive investments that happen to outperform many higher-fee, actively traded funds. They are designed to replicate the performance of financial market indexes, like the S&P 500, and are ideal for long-term investing, such as retirement accounts.

While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management. Despite these limits, index funds are often favored for their consistent performance and are now a staple in many investment portfolios. Consider your investment objectives and risk tolerance when choosing an index fund. Talking first with a financial advisor for personalized advice is always prudent.