In 2025, 79% of actively managed large-cap U.S. stock funds earned less than the S&P 500, according to the SPIVA U.S. Year-End 2025 Scorecard from S&P Dow Jones Indices. That was not a fluke year. The same research has tracked active funds for 25 years, and over long stretches the share that falls behind the index climbs to roughly nine in ten. Professional managers with research teams, data feeds and decades of experience mostly fail to beat a fund that simply owns the whole market.
That fund is an index fund, and it is the default building block for most people who invest for retirement. Here is how it works and why it keeps winning.
Key takeaways
- An index fund buys every security in a market index, such as the S&P 500, instead of trying to pick winners.
- Its advantage comes mostly from low costs and low turnover, not from clever timing.
- Most active managers trail their benchmark over 10- to 20-year periods, and the ones who win rarely keep winning.
- A beginner can build a diversified portfolio with one to three broad index funds.
What an index fund actually owns
An index is just a list with rules. The S&P 500 is roughly 500 large U.S. companies weighted by market value. The CRSP US Total Market Index covers nearly every publicly traded U.S. stock. The Bloomberg U.S. Aggregate Bond Index tracks investment-grade bonds. A committee or a formula decides what goes on the list; nobody is betting on which stock will do best next quarter.
An index fund buys what is on the list in the same proportions. If one company makes up 7% of the index, it makes up about 7% of the fund. When a company leaves the index, the fund sells it. That is the whole strategy. You get the market’s return, minus a small fee, with no attempt to do better.
Index funds come in two wrappers: traditional mutual funds and exchange-traded funds. The holdings can be identical. The differences are in how you buy them, minimums and taxes, which we cover in ETF vs. mutual fund.
Why owning everything beats picking
The logic is arithmetic more than finance. Before costs, all investors in a market together earn the market’s return, because together they are the market. Active investors as a group therefore earn the average too, before they pay for research, trading and management. After those costs, the average active dollar has to land below the average indexed dollar. Some managers beat the market in any given year, but they are offset by others who lag, and everyone in the active camp pays more to play.
Three costs do most of the damage:
- Expense ratios. Broad stock index funds from large providers such as Vanguard, Fidelity or Schwab often charge a few hundredths of a percent a year. Many active funds charge ten or twenty times that.
- Trading costs. Active funds buy and sell more often, paying spreads and commissions that do not show up in the expense ratio.
- Taxes. Frequent selling in a taxable account generates capital gains distributions that shareholders owe tax on, even if they never sold a share themselves.
What a fee gap does over 30 years
Take a hypothetical $10,000 left alone for 30 years in a market that returns 7% a year. In a fund charging 0.05%, it grows to about $75,000. In a fund charging 1%, it grows to about $57,400. The 0.95-point difference looks tiny on paper and costs more than $17,000 on a single deposit. Add years of regular contributions and the gap runs into six figures; our article on expense ratios runs those numbers.
The winners don’t stay winners
A fair objection: why not just find the managers who do beat the index? The trouble is spotting them ahead of time. S&P’s separate Persistence Scorecard follows top-performing funds to see whether they stay on top, and the answer is usually no. Year after year, only a small fraction of funds that rank in the top quarter over one stretch are still in the top quarter a few years later. Past results are a weak signal, and you pay the active fee either way.
None of this means indexing guarantees anything. An S&P 500 fund falls when the S&P 500 falls, and the drops can be steep. In 2008 the index lost more than a third of its value. An index fund removes the risk of picking the wrong manager. It does not remove market risk.
What to compare when choosing an index fund
Two funds tracking the same index are close substitutes, so the comparison is mostly about cost and fit:
- The index itself. S&P 500 funds hold large U.S. companies only. Total market funds add mid-size and small companies. International funds cover the rest of the world. Bond index funds cover debt.
- Expense ratio. Lower is better when the index is the same. Look on the fund’s fact sheet or prospectus.
- Tracking difference. How closely the fund’s return has matched its index after fees. A well-run fund trails by roughly its expense ratio.
- Minimum investment. Some mutual funds require $1,000 or $3,000 to start. ETFs cost one share, and many brokerages now sell fractional shares.
- Where you will hold it. Your 401(k) menu may offer only one or two index options. Pick the cheapest broad one available there.
Getting started
A simple, workable setup has three steps.
- Pick the account. If your employer matches 401(k) contributions, start there; the match is covered in our 401(k) match guide. Otherwise, an IRA or a regular brokerage account works.
- Pick a core fund. A total U.S. stock market or S&P 500 index fund is the usual anchor. A total international stock fund and a total bond market fund round it out. Many people stop at those three.
- Automate it. Set a recurring contribution on payday and leave it. Automatic investing removes the temptation to wait for a better moment.
If choosing a mix feels like too much, a target-date index fund holds stocks and bonds in one package and shifts toward bonds as the target year approaches. The fee is usually a little higher than buying the pieces separately, but for many beginners the simplicity is worth it.
Frequently asked questions
How much money do I need to buy an index fund?
Very little. Index ETFs trade for the price of one share, and brokerages that offer fractional shares let you start with a few dollars. Some index mutual funds have minimums in the low thousands, but many 401(k) plans waive them.
Is an S&P 500 fund diversified enough on its own?
It spreads your money across hundreds of large U.S. companies, which is far better than a handful of stocks. It still leaves out smaller companies, international markets and bonds. Many investors add at least an international fund and, as they near retirement, a bond fund.
Do index funds pay dividends?
Yes. Stock index funds pass along the dividends paid by the companies they hold, usually quarterly. You can have them reinvested automatically, which buys more shares and keeps your money compounding.
Can an index fund go to zero?
For a broad fund, that would require nearly every company in the index to fail at once. The realistic risk is a deep, prolonged decline, which is why money you need within a few years generally belongs somewhere steadier than stocks.
