Index Funds Are: How They Work And Why Investors Use Them

Erwanto

05 Januari 2026

Reviewed by Gotrade Internal Analyst

Index Funds Are: How They Work And Why Investors Use Them

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If you have ever searched for beginner friendly investing ideas, you have probably seen the term index fund.

Index funds are one of the simplest ways to invest in the stock market without picking individual companies. They are popular with long term investors who want broad diversification at low cost.

This guide explains what an index fund is, how it works, the pros and cons, and how it compares to ETFs.

What Is An Index Fund?

An index fund is a pooled investment that aims to match the performance of a specific market index, not beat it.

Examples of popular indexes include:

S&P 500, which tracks 500 large US companies
Nasdaq 100, which focuses on major tech and growth stocks
MSCI World, which covers developed markets globally

An index fund buys the stocks (or bonds) inside that index in the same weights, so if the index goes up 7 percent in a year, the fund tries to deliver roughly the same result before fees.

You can find index funds in two main forms:

Traditional index mutual funds
Index ETFs, which trade on exchanges like a stock

Both follow the same core idea, they simply use different wrappers.

How Do Index Funds Work?

1. Passive, rules based approach

Index funds follow a passive strategy.

Instead of a manager trying to pick winners and time the market, the fund simply follows the rules of the index, for example:

Which companies qualify?
How much weight each company gets?
When the index is rebalanced?

This rules based structure is what keeps costs low.

2. Diversification in a single product

When you buy one index fund, you get exposure to many companies at once.

An S&P 500 index fund gives you hundreds of large US stocks
A total market fund covers large, mid and small caps
A global index fund spreads your money across multiple countries

That diversification helps reduce the impact of a single company performing badly.

3. Low ongoing fees

Because index funds do not pay analysts to research and trade actively, they usually charge much lower fees than actively managed funds.

Lower fees matter a lot over decades. Every 0.5 percent saved in costs is 0.5 percent that can keep compounding for you instead.

Index Fund vs ETF: What Is The Difference?

The term index fund describes the strategy. ETF describes the wrapper.

You can have:

Index mutual funds
Index ETFs

Many index ETFs track the same benchmarks as classic index mutual funds. The main differences are in how you buy and hold them.

Index mutual funds

Typically bought directly from the fund provider
Trades are usually executed once per day at the closing price
Often have minimum initial investment amounts

Index ETFs

Trade on exchanges throughout the day like a stock
You can buy a single share, and often fractions of a share
Prices move in real time with supply and demand

If you use an app like Gotrade, you will usually gain index exposure through US listed index ETFs, for example an S&P 500 ETF or a global equity ETF.

These work very similarly to index mutual funds in practice but are more flexible for smaller, frequent investments.

Benefits of Index Funds

1. Simple to understand

You do not need to be an expert stock picker.

You are buying “the market” or a defined slice of it, not betting on a single company.

2. Diversification

Index funds spread your money across many holdings.

This reduces company specific risk compared to owning just a few stocks.

3. Low cost

Expense ratios are often a fraction of those charged by active funds.

Over time, that cost gap can translate into a meaningful performance difference.

4. Easy to combine with DCA

Index funds work well with dollar cost averaging.

You can invest a fixed amount every week or month into the same index fund or ETF and let compounding do the heavy lifting.

Risks and Limitations of Index Funds

Index funds are not risk free.

You still face market risk. If the overall market falls, your index fund will fall too.
You get the average return of that index, not the chance of outperforming it.
Some indexes are very concentrated in a few large companies, so they may be less diversified than they look.

There is also tracking error, which is the small gap between the index return and your fund return after fees and costs. For most large, liquid index funds, this gap is usually small.

How To Start With Index Funds?

You can access index funds and index ETFs through most major brokerages and investing apps.

With an app like Gotrade, you can:

Buy US listed index ETFs that track major benchmarks
Start from as little as 1 dollar with fractional investing
Spread your money across several index ETFs for global diversification

The core steps are simple:

Decide which index or combination of indexes fits your goals
Choose a low cost index ETF that tracks that benchmark
Set a regular investment schedule if you want to use DCA
Stay consistent through market ups and downs

GET GOTRADE & BUY INDEX ETF

Conclusion

An index fund is a low cost, diversified way to invest in a stock or bond market by tracking an index instead of trying to beat it.

For many retail investors, index funds and index ETFs are the foundation of a sensible long term portfolio. They are simple to understand, easy to automate and allow you to focus on your savings rate and time in the market instead of short term noise.

If you want to start building an index based portfolio in US markets with small amounts, you can use an app like Gotrade to buy fractional shares of US listed index ETFs from as little as 1 dollar and let compounding do the rest over time.