Index Funds 101: Tracking Indices, Sectors, and Industries

Index funds—those typically low-expense-ratio, passively managed funds that attempt to mirror the performance of stock indices—are a common choice among long-term investors. Here’s a quick primer. growth chart: Index funds, sector funds, tracking indices
5 min read
Photo by Getty Images

Key Takeaways

  • Index funds are baskets of assets designed to mimic a specific underlying index

  • Some well-known index funds are based on the S&P 500, Dow Jones Industrial Average, Russell 2000, and MSCI EAFE 

  • Passively managed funds typically have low expense ratios compared to actively managed products

You’ve probably heard of index funds. Much like other mutual funds and exchange-traded funds (ETFs), index funds consist of a basket of assets designed to mimic the performance of an index. But index funds are passively managed. So what are index funds? What makes them attractive? What are the risks? And how do you know if they’re a good fit for your portfolio?

What Is an Index Fund?

Index funds are mutual funds without the “what to own” decisions of active management. There are many types of index funds, all designed to track the movements of various sectors, markets, asset classes, or industries. Many top index funds are based on the S&P 500 Index (SPX), which, as the name implies, is an index of roughly 500 large companies listed on U.S. stock exchanges, weighted by market capitalization.

There are also index funds that focus on sectors, such as technology, industrials, materials, and more. Index funds can cover industry groups, like home building or aviation, or asset classes based on commodities or currencies.

Index funds are popular because they offer a form of instant diversification. With one purchase, investors can own a wide swath of companies.

Because index funds aren’t actively managed, they’re often referred to as “passively managed.” That means they follow an underlying index, so there’s less need for the manager to buy or sell components (unless the index itself changes).

That means fees can be kept down. Index funds typically have low expense ratios compared to actively managed funds, where more buying and selling decisions are required to meet the goal of outperforming an index. Plus, index funds can help diversify a portfolio without single-stock risk.

In recent years, most index funds have enjoyed solid gains following the U.S. bull stock market. The S&P 500 Index has had an annualized average return of around 10% since its inception in the 1920s through 2019, according to data from Yahoo! Finance. But from 2000 to the middle of 2020, the SPX more than doubled.

Of course, index funds carry all the same risks as the underlying indices. An index fund is also less flexible than an actively managed mutual fund, where a manager can pull out individual stocks they think will underperform and replace them with stocks expected to do better, so the upside is limited as well.

Index funds, like other mutual funds, differ from ETFs, which trade throughout the day. Index funds trade once per day, at the market close. Mutual funds are often actively managed, so they often have higher operating costs than index-based mutual funds.

Investing in Index Funds

How do you know if index funds are right for you?

“I always discuss taking a top-down approach when thinking about index funds,” said Patrick Mullaly, an education coach at TD Ameritrade. “The first question to ask is, are you a passive or active investor?”

Taking it from the top, investors interested in benefiting from the performance of the overall stock market might choose an index fund based on a broad index like the SPX, Nasdaq-100 (NDX), the small-cap Russell 2000 (RUT), or the venerable Dow Jones Industrial Average ($DJI).

After that you might sit back and passively watch the performance of the index.

But as Mullaly pointed out, you can also use index funds for more “active” investing.

For example, you might look to an S&P 500 Index fund to track the performance of the underlying index. But if you think the Technology sector will outperform the SPX, you could invest in a tech-sector fund or allocate some resources to the focused fund and some to the broader index fund. The goal is to magnify gains and potentially benefit from an increase in the broad index—plus get a boost if the technology index also does well.

“Index funds are relatively easy to understand and you can take a hands-off approach, but if you have the time to educate yourself and drill down, you can look into the sector indices as well,” Mullaly said.


Key Takeaways

  • Index funds are baskets of assets designed to mimic a specific underlying index

  • Some well-known index funds are based on the S&P 500, Dow Jones Industrial Average, Russell 2000, and MSCI EAFE 

  • Passively managed funds typically have low expense ratios compared to actively managed products

Related Videos

Call Us

Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.

Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

Investors cannot directly invest in an index.

Carefully consider the investment objectives, risks, charges, and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.

ETFs can entail risks similar to direct stock ownership, including market, sector, or industry risks. Some ETFs may involve international risk, currency risk, commodity risk, and interest rate risk. Trading prices may not reflect the net asset value of the underlying securities. Commission fees typically apply.

Mutual funds, closed-end funds, and exchange-traded funds are subject to market, exchange rate, political, credit, interest rate, and prepayment risks, which vary depending on the type of mutual fund. Fund purchases may be subject to investment minimums, eligibility, and other restrictions, as well as charges and expenses. Certain money market funds may impose liquidity fees and redemption gates in certain circumstances.


Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.

TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2022 Charles Schwab & Co. Inc. All rights reserved.

Scroll to Top