What is an Index Fund?
There are over 20,000 investment products available today that come in all shapes and sizes. This is the first of several posts to help distinguish between the various product options.
An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is designed to provide broad market exposure, low operating expenses and low portfolio turnover.
“Indexing” is a passive form of fund management that has been successful in outperforming most actively managed mutual funds. While the most popular index funds track the S&P 500, a number of other indexes, including the Russell 2000 (small companies), the Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Lehman Aggregate Bond Index (total bond market) are widely used for index funds.
The primary advantage in utilizing index funds is the lower management expense ratio. Also, a majority of mutual funds fail to beat broad indexes, such as the S&P 500.
The S&P 500® has been widely regarded as the best single gauge of the large cap U.S. equities market since the index was first published in 1957. But you couldn’t go out and buy the S&P 500. It wasn’t until the 70’s that the Vanguard 500 index fund was available for the individual investor. Since then, the experts have weighed in on the advantages and disadvantages to passive vs. active investment options. Understanding the difference between the two will help you make decisions around these varying options.