Index Funds 101

Yesterday, I offered some insight into my preferred investing strategy – passive investing.  I also mentioned that my strategy lends itself to index investing.  So today I figured we would 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 Russell 2000, 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 indexes are the most well known, you can also find bond indexes, commodity indexes, and indexes 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 can benefit your return) and low portfolio turnover (which can help with taxes).

The combination of a diverse portfolio, low tax consequences, and low costs make index funds an attractive investment option.