Index Funds 101

I can’t analyze stock indexes without mentioning my favorite investments – index funds.  Index funds fit squarely into a low-cost, diversified investing strategy that can help you benefit from the ups and downs of the market.  So today I explore the wonderful world of index funds.

What is an index fund?

An index fund is a mutual fund that replicates the performance of a particular investment index. When most people talk about index funds, they usually mean a stock index fund. These funds invest in the same stocks, in the same proportion, as the index it follows. Some common indexes are the Dow Jones Industrial Average (the Dow), the S&P 500, the Nasdaq, and the Wilshire 5000.

These indexes aren’t investments themselves; they reflect the relative value of a group of stocks. In other words, a particular index represents the market average of the stocks it contains. So when people talk about “beating the market,” they are referring to having higher returns than the comparable index.

Although stock index funds are the most well known, you can also find bond index funds, commodity index funds, and funds specific to an industry like real estate.  Here is an example of the Vanguard 500 Index fund (replicating the S&P 500).

Index funds strive to match market returns

Because index funds mirror their respective benchmarks, they strive to match markets returns, not beat them The mutual fund manager merely keeps the proportion of the stocks in the index fund in line with the stocks in the benchmark index.

By comparison, actively managed funds have a specific strategy that a manager implements to outperform the market. The manager buys and sells stocks, bonds, and/or money market instruments in order to make sure that the mutual fund fulfills its purpose. This buying and selling also takes research, analysis, and administration. Consequently, the manager and his staff that perform these tasks cost money…a lot of it. And those costs pass to you as an investor in that actively managed fund.

Benefits of index funds

Index funds provide broad exposure to the market. This broad exposure reduces your investment specific (unsystematic) risk. Index funds also have low operating costs (which benefit your return) and low portfolio turnover (which helps with taxes).

A word of caution though: many types of index funds have been created because of their increasing popularity, some of which are not necessarily low cost or diversified. So be aware of the expense ratio of the funds you invest in; many good index funds have operational costs of .05 – .20%. Also choose funds fit your desired asset allocation.

The combination of a diverse portfolio, low tax consequences, and low costs make index funds an attractive investment. In addition, since the majority of active funds don’t outperform their benchmarks, they are worth looking into.