Index Funds: What They Are and How to Invest

Index fund is one of the most beginner friendly financial instruments if you want to start learning about investing in US stocks. You basically just buy an index fund to get hundreds of companies part of stocks all at one index

One of the most popular indexes in the market and you probably have heard of is S&P 500 index because this index contains 500 large stocks in the US market, and will be mentioned a lot in this article.

What is an index fund?

An index fund is an investment instrument built to follow the market index performance rather than outperform it. The index itself is not something you can buy. It is a list of publicly traded stocks compiled by index providers like S&P Dow Jones Indices, FTSE Russell, and MSCI.

The index providers will decide which stocks are included in their index and also their weightings, this is different from an actively managed fund where they decide stocks based on their research with the purpose of outperforming the benchmark index which is why they cost more to run and their depends heavily on the manager’s decision.

How does an index fund work?

Theoretically index fund works in three phases: the index provider establishes the rules, the fund replicates the index's composition, and your returns track the index and net of fees.

All these processes do not have a subjective judgment involved and nothing in this process involves forecasting.

1. The index provider sets the rules

Every index has their own benchmark, the index committee will decide stocks based on size, liquidity, domicile, and earnings history. After all the list is complete, a weighting method will determine the proportion of each stock, usually their standard approach is market-cap weighting which means larger companies will have a greater proportion.

Companies may be added to or removed from the index on rebalancing schedule, it is when an index reviews their company composition.

2. The fund replicates the holdings

On this stage the listed stocks will be purchased with two different approaches: a full replication which buys every stocks in the index list at their weight and there is sampling which buys a subset of stocks that represent the index's characteristics.

When new funds from investors come in, they are purchased in the same proportion as when funds are withdrawn. But, this process is not perfect, there will be a “tracking error” which comes from transaction costs, execution timing, uninvested cash, and management fees.

3. Your return tracks the index, minus costs

Next, there is an annual management fee or expense ratio which is deducted daily from the fund's assets and as for dividends, those generated by the stocks within the index continue to flow into the fund, depending on the specific product.

For index funds, the value per unit is known as the NAV (Net Asset Value) and calculated once daily after the market closes.

What are the types of index funds?

There are three types of index funds based on; what they track, how you buy them, and how holdings are weighted.

1. By what they track

• Broad market funds track major indexes, such as the S&P 500.

• International funds track indexes outside the US such as the MSCI World or FTSE

• Sector funds track sub-indexes, such as technology or healthcare.

• Bond funds track aggregate bond index; they are generally used for income generation and to offset stock market volatility.

2. By how you buy them: mutual funds vs ETFs

Index mutual funds are executed once a day at the NAV calculated after the market closes and Index ETFs trade on exchanges throughout market hours, with prices fluctuating every second, since ETFs trade like ordinary stocks, there is a difference between the buying and selling prices known as the "spread." on a fund such as the Vanguard S&P 500 ETF (VOO), that spread is narrow because trading volume is high. On thinly traded sector ETFs, it is wider and worth checking.

Regarding minimum capital, index mutual funds often require a specific initial investment. ETFs have no such minimum: you buy shares at the market price, Also, you can purchase a small fraction of a single share on a supported platform like Gotrade App.

3. By weighting method

There are four weighting methods:

• Market-cap weighting which is the most common will let a companies with large market values receive a significant share of the fund.

• Equal Weighting will let every stock gets the exact same percentage share.

• Fundamentally Weighting which is allocated by metrics like sales, revenue, or dividends.

• Price Weighting which is allocated strictly by the stock's share price.

Why do index funds matter?

Actively managed funds lose to the benchmark over time

Index funds matter because most actively managed fund struggle to beat their benchmark over the long term and because cost is one of the few variables an investor controls, according to the S&P Dow Jones Indices SPIVA US. Scorecard, 89.93% of actively managed US large-cap equity funds lagged behind the S&P 500, while for the 15-year period, the figure was 85.59%.

Expense ratio gap over 30 years

Expense ratio is also one of the reasons, according to the Investment Company Institute’s report on investment fund fees, the asset-weighted average expense ratio for US equity index funds was 0.05% in 2025, whereas actively managed funds stood at 0.64%. A difference of 0.59 percentage points is small, but remember, the amount deducted annually from the total balance will accumulate over time.

Here is an example of a fixed US$10,000 investment at 7% rate a year before fees for 30 years.

Another thing is simpler, that that purchasing a fund lets you own a piece of the many listed companies at once at a very low cost without the need to buy them individually.

What are the risks and things to watch?

Index funds are not without risk, instead of taking on the risk of picking individual stocks, you take on the risk of the overall market.

1. Market risk

An index fund will also fall when its underlying index drops, there is no built-in mechanism to buffer the decline. If the S&P 500 undergoes a 20% decline, the fund tracking will drop equally.

2. Currency risk

If you are investing outside of the US domicile and invest in a US dollar-denominated fund, exchange rate fluctuations can increase or decrease your investment returns regardless of what happens in the US stock market.

3. Fees and tracking error

Annual fees will accumulate over time and also a fund will never exactly match its index. This discrepancy is known as "tracking error," and this is usually reported in the product fact sheet.

4. Concentration inside the index

Highly concentrated market cap weighted indexes are an important counterpoint to diversification claims, to illustrate, the S & P Dow Jones index reported that information technology alone made up 34.4% of the S&P 500's weight at the end of 2025. Its not diversification when the overall direction of the index is largely determined by the largest companies.

How to get started with index funds on Gotrade

Here are the steps to start investing in ETFs with Gotrade:

1. Download and open a Gotrade account and complete the identity verification process.

2. Add funds into your account.

3. Search for your desired ETF using its ticker symbol

4. Specify the purchase amount rather than the number of shares.

5. Submit your order, and check your position on the portfolio page.

The index price will move every trading day. Check the latest figure in the app before calculating your purchase amount. Here is a simulation for your first index funds purchase.

Conclusion

If you want to start investing, index funds are a go-to, and you need three decisions on choosing a market index, set the regular contribution amount you want to make, and commit yourself to a long run investment, because index funds reward consistency and not a perfect market entry timing.

Buy US stocks starting from $1 with fractional shares, so you can adjust your position size to fit your budget each month. Open a Gotrade account when you are ready.