By Stephen W. Bedikian, Associate Wealth Advisor
An index fund is a type of investment fund that automatically owns most or all of a market index like the S&P 500. The structure of the index fund can be a mutual fund or ETF. Mutual funds are generally bought and sold directly through the fund company at a price calculated at the end of the trading day (called the net asset value, or NAV) while an exchange-traded fund (ETF) trades throughout the day on an exchange like the NYSE or NASDAQ.
An index fund is characterized as a passive investment because the fund simply buys the constituent stocks of an index (500 stocks for the S&P 500) and holds them whereas an actively managed fund may trade stocks frequently and invest selectively in some stocks while avoiding others.
Because most early ETFs were passive index funds, the perception still exists that ETFs are all passive, however, many exotic ETFs have hit the marketplace in the last decade including commodity-linked ETFs, volatility-linked ETFs, and 2x and 3x leveraged ETFs that are actively managed. An active fund seeks to outperform an index while a passive fund simply seeks to match the performance of an index less fees.
Key Takeaways About Index Funds
- Index funds offer broad market exposure at low cost. By tracking an index like the S&P 500, they offer diversification and minimize fees compared to many actively managed funds.
- Performance and simplicity have fueled their growth. Decades of data show most active funds underperform their benchmarks over time, driving investors toward passive strategies.
- Index funds aren’t risk-free. Market concentration, valuation blind spots, and mechanical selling during downturns can amplify volatility in capitalization-weighted indexes.
- Index funds generally work best as part of a broader strategy. Many investors combine index funds with active management and other asset types to help balance efficiency, risk management, and opportunity.
Massive fund flows into index funds and other passive strategies
The growth of index funds and passive investing in general represent one of the biggest changes to the investment industry in the past two decades. At the turn of the century, passively managed assets represented a percentage of total assets in the low teens. That share has grown to about 54% in 2025, reaching $19.1 trillion in invested assets according to fund research company Morningstar. In other words, for every new dollar invested today, more than half goes into an index fund—
The growth of passive investing versus active investing has likely been driven by a simple fact: performance. S&P Global reported that more than 78% of active funds invested in U.S. markets underperformed their benchmark index in 2024. The results are even worse when looked at over a long period of time. Over the 10-year period ending 12/31/24, more than 89% of all active U.S. domestic funds underperformed their benchmark index after fees.
The low-cost advantage of index funds
Another advantage of index funds is that their fees tend to be significantly lower than actively managed funds.
For example, the huge Vanguard S&P 500 ETF (ticker symbol: VOO) charges a fee of just 0.03%. That’s just thirty cents annually for every $1,000 you invest. Vanguard can charge ultra-low fees because the fund manages $1.5 trillion dollars in assets and there is no active management required: no expensive team of analysts and portfolio managers to evaluate and select stocks—and minimal trading costs because of the buy and hold strategy.
The portfolio simply mirrors the S&P 500 index on a market capitalization-weighted basis. Every additional dollar invested in the fund is mechanically invested to mirror the stocks in the S&P 500 index.
The S&P 500 is perhaps the most widely followed index; other heavyweights include:
- The narrower Dow Jones Industrial Average or “the Dow,” which is composed of just 30 stocks versus the 500 contained in the S&P 500;
- The Nasdaq Composite, which is heavily weighted toward technology and growth companies and contains over 3,000 companies; and
- The Russell 2000, which is the primary benchmark for small-cap companies.
How to invest in index funds
To invest in an index fund, you purchase shares—just as you would invest in a stock or an actively managed fund. There are hundreds of indices worldwide, including ETFs tied to indices for a range of countries; sectors and industries; and market segments like growth or value. Investors can choose to invest in ETFs tied to a broader index like the S&P 500, or a narrower index of small cap companies in a specific country. There are also indexes for bonds.
New indices are regularly created by leading providers like S&P Global, MSCI, FTSE Russell and Nasdaq. These companies create an index to track a specific sector based on company size, a segment like value or growth, or a geographic location—and then update the index components, typically on an annual basis.
The stocks of companies that are expected to join a popular index like the S&P 500 often rise in anticipation of an announcement. This can happen because all the mutual funds and ETFs that are based on that specific index will likely be need to buy the stocks of the new index components in order to maintain the proper allocation.
Conversely, if a company is removed from the index, its stock typically declines as index-based funds must then sell the stock—putting downward pressure on its price.
Do index funds pay dividends?
An index fund passes through dividends paid by the constituent companies in its allocation to its shareholders. The actual dividend yield for each index varies widely.
For example, the Morningstar stated SEC yield, as of February 13, 2026, of the State Street SPDR S&P 500 ETF (SPY) is 1.02% but the State Street SPDR Portfolio S&P 500 High Dividend ETF (SPYD) has a yield of 4.55% because that index is composed only of about 80 high-dividend paying companies out of the total 500 companies.
The downsides to index investing
Is there a downside to index or passive investing? These investments are not the perfect answer for all investors in all market environments. Here’s an example: A market-weighted index like the S&P 500 is heavily skewed toward the highest valued companies. While there are 500 companies in the index, as of February 12, 2026, Nvidia has a weight of 7.34% because it’s the most highly valued company in the index. More than a third of the index value is in the technology sector; an investor who may want broad-based exposure is actually making a heavy bet on this one sector—technology.
typically allocate based on market capitalization.
An extreme example of this is an AI-darling Palantir Technologies. In 2025, Palantir generated more than $4 billion in annual revenue but has the 31st largest weight in the S&P 500 index, as of February 12, 2026. While the stock price is very volatile, it trades at a price-to-earnings ratio (PE ratio) of over 200, as of February 13, 2026. Contrast that valuation with Internet and cable TV provider Comcast, which had over $120 billion in annual revenue in 2025, but is valued at a PE ratio of less than 6 as of February 13, 2026, and its index weight is 97th as of February 12, 2026. In a down market, the stocks of companies trading at extreme earnings multiples tend to decline further than the overall market.
Investors can help mitigate the valuation risk to some extent by choosing an index fund that allocates based on equal weight instead of capitalization-weighting. An equal-weight fund simply allocates equally to all companies in the index. For example, Nvidia constitutes just 0.19% of the assets in the Invesco S&P 500 Equal Weight ETF (RSP), as of February 12, 2026, instead of the 7.75% of the Vanguard S&P 500 ETF (VOO), as of December 31, 2025, which allocates based on market-capitalization weighting.
Perhaps the biggest risk in holding these vehicles would be an exogenous event like a major recession or war that causes investors in aggregate to shift money out of stocks. Because a majority of equity assets are passively invested, when fund flows reverse, stocks with the largest market capitalizations will be mechanically sold. In other words, the passive fund flows that have pushed up the value of shares like Nvidia can potentially go into reverse—and disproportionately pressure the company’s stock price.
Build the mix of active and passive investing that’s right for you
Often investors will hold both actively managed and passively managed investments to help protect themselves. Active managers can also potentially outperform in narrow sectors like biotechnology that have a highly diverse set of companies with many low-quality companies that investors may want to .
In addition, passive investments are usually publicly traded and an allocation to private investments may help enhance performance in certain sectors. Have a conversation with your Halbert Hargrove advisor about the right balance for your portfolio.
Learn more about Halbert Hargrove’s investment services.
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