Index funds make money for their investors in three ways: dividend and interest income from the securities they hold, capital gains distributions when the fund sells holdings at a profit, and a rising net asset value (NAV) when the value of the fund’s portfolio goes up.
An index fund is a mutual fund or ETF that follows a passive strategy, buying the securities in a chosen index so it earns roughly the same return as that index before fees. When the companies it owns pay dividends, or the bonds pay interest, the fund passes nearly all of that income, less expenses, to shareholders. When it sells a security that has risen in price, it distributes the net capital gains, usually at year end. You can usually take these payments in cash or reinvest them in more shares. Because index funds trade less than actively managed funds, they tend to have lower transaction costs, fewer realized capital gains and lower fees. Fees are deducted from NAV, so they reduce your return. Index funds are not FDIC-insured, and you can lose money if the index falls.
Source: Investor.gov (U.S. SEC), Mutual Funds and Exchange-Traded Funds (ETFs)
Image: New York Stock Exchange trading floor, photo by Carol M. Highsmith, public domain, Library of Congress via Wikimedia Commons.