1. Money

What Are Index Funds?

The Ins and Outs of Index Funds

By

Index funds are mutual funds that are intended to track the returns of a market index. An index is a group of securities that represents a particular segment of the market (stock market, bond market, etc.). Among the most well-known companies that develop market indexes are Standard & Poor's and Dow Jones.

Index funds will hold almost all of the securities in the same proportion as its respective index. Index funds can be structured as a mutual fund, an exchange-traded fund, or a unit investment trust. Several well-known companies that offer index funds are Vanguard, Fidelity and T. Rowe Price.

Index Funds are Passively Managed

Index funds are considered to be passively managed because the portfolio manager of each index fund is replicating the index, rather than trading securities based on his or her view of the potential risk/reward characteristics of various securities. Conversely, an actively-managed fund has a portfolio manager who is buying and selling securities based on an opinion about which securities will accomplish the fund's objectives.

Index Funds Come in Different Shapes and Sizes

Indexes come in many varieties. Some indexes may include nearly all of the stocks in the U.S. (such as the Wilshire 5000 Index) or other countries (such as the MSCI Brazil Index). Indexes may also be subsets of other indexes. For example, Standard & Poor's breaks down the S&P 1500 Composite Index into a number of different indexes. The S&P 500/Citigroup Value Index includes the stocks with the largest stocks in the S&P 1500 that are considered value stocks. The S&P SmallCap 600/Citigroup Growth Index includes the smallest stocks in the S&P 1500 that are considered growth stocks.

In recent years, more obscure indexes have been created to allow investors the opportunity to take advantage of markets that are more specialized. Investors who want to invest in commodities, foreign currencies, or socially-responsible companies can now look to index funds.

Fees of Index Funds

Index funds have expense structures that are similar to other mutual funds. As with other mutual funds, index funds have various share classes depending on the fund company (Class A, B, C, etc.) Generally, the total costs of owning an index fund are less than an actively-managed fund. However, those total costs depend largely on the fund company offering the funds and the index which the fund tracks. In other words, you can't safely say that all index funds are cheaper than all actively-managed funds.

How Much Do Index Funds Cost?

If you want to invest in diversified U.S. large cap index funds, you might buy the Vanguard 500 Index Fund Investor Shares. In doing so, you wouldn't pay an upfront sales charge, and your total ongoing expense ratio is a reasonable (if not downright cheap) .15%. Don't assume that all index funds are cheap. For example, the ProFunds Bull Investor Fund also tracks the S&P 500 Index and sports a hefty expense ratio of 1.50%; that's ten times more than the Vanguard 500 Index Fund. After you decide which index you want to buy, be sure to research the costs of the investment options.

Indexes, Indices and Tomatoes

Some investors and investment professionals might get confused when they hear Dow Jones refer to their "indexes" and Standard & Poor's refer to their "indices" (in-dah-sees). The difference between indexes and indices is only in the spelling and, of course, the pronunciation. Some people eat "tomatoes" while others eat "ta-mah-toes."

  1. About.com
  2. Money
  3. Mutual Funds
  4. Active vs. Passive
  5. Index Funds - What Are Index Funds?

©2014 About.com. All rights reserved.