What Is An Index Fund?

What is an index fund? The long-term benefits of an index fund apply to all markets. An index fund, according to Michelle Smith and the Mutual Fund Education Alliance is "A mutual fund that seeks to mirror...

An index fund, according to Michelle Smith and the Mutual Fund Education Alliance is "A mutual fund that seeks to mirror general stock-market performance by matching its portfolio to a broad-based index, most often the Standard & Poor's 500-stock index." These funds tend to have lower overall expenses because portfolio choices are automatic and passively managed. There are pure index funds, which are managed to match as close as possible the performance of the market. An enhanced index fund also tracks to an index, but makes an extra effort to boost returns by branching out to take advantage of market shake-ups and other reasons.


These funds are great for investors who are looking to buy and hold. They are typically interested in a slow growth over time, instead of jumping in, out and around trying to beat the market. Because index funds aim to have the exact percentages as the securities on the particular index, fewer staff members can manage them. Computers are set up to monitor the index and make changes. Some of these fund's expenses are as low at 0.18% whereas a fully managed mutual fund may run expenses up to 3.0% or more.




Other indices that are used besides the Standard & Poor's 500 are the NASDAQ 100, Wilshire 5000 and the Russell 2000. Indices are created using different methods. The market value-weighted method creates an index that has each stock in it weighing proportionally to its market capitalization. Another method is the price weighted method with each stock weighing in proportion to its market price. A third way is the equal weighted method where each stock has equal weight in the index. The Standard & Poor's 500 index is created using the market value weighted method.

One advantage for index funds is that they can avoid mistakes made by a too-active fund manager. If the fund manager makes a wrong decision or is not invested in the right stocks, it can cost you a lot of money. Over the long-term, index funds have outperformed actively managed funds by a large margin. These can be a great choice for persons who do not like a lot of risk and can sit back and let the market take its course.

With mutual funds, they are required by law to pay capital gains on a yearly basis. An active mutual fund may have many transactions over the course of the year. This will generate more expenses, which means fees are higher or will go higher. Because an index fund changes stocks less frequently, fewer taxable distributions are made. This lack of distributions means more money stays in the fund to keep growing, which will increase the total rate of return for an investor.

The long-term benefits of an index fund apply to all markets. People tend to think that index funds are only for large-company stocks. However, indexes are used in the bond market, international markets and small-company stocks. All of these choices mean that you can have great diversity as well as the low costs and turnovers.

© High Speed Ventures 2011