An index, with regard to investing, is a sampling of stocks or bonds that represent a particular segment of the overall financial markets. For example, the Standard & Poor’s 500 (S&P 500), is an index representing roughly 500 of the largest US companies, such as Wal-Mart, Microsoft and Exxon Mobil.
There are three primary reasons that investors may want to use index funds for their own investment strategies. These reasons are passive management, low expenses, and broad diversification.
- Passive Management: Mutual funds can either be actively-managed or passively-managed. The manager of an actively-managed stock mutual fund, for example, is actively buying and selling stocks with the goal of "beating the market," which is measured by a particular benchmark, such as the S&P 500. There is significant risk, however, that the active manager will make poor decisions and under-perform the S&P 500 (more than two-thirds of actively-managed funds do not outperform the indexes for periods longer than 10 years).
- Low Expenses: Low costs are a large advantage for index funds and the cost savings translate to higher returns for the investor. For this reason, look for the index funds with the lowest expense ratios.
- Broad Diversification: An investor can capture the returns of a large segment of the market in one index fund. Index funds often invest in hundreds or even thousands of holdings; whereas actively-managed funds sometimes invest in less than 50 holdings. Generally, funds with higher amounts of holdings have lower relative market risk than those with fewer holdings; and index funds typically offer exposure to more securities than their actively-managed counterparts.
In contrast, the manager of an index fund, which is passively-managed, is seeking only to buy and hold securities that represent the given index for purposes of matching the performance of the index, not to beat it. In summary, the reason passive management is good for the investor is captured in the saying, "If you can't beat 'em, join 'em."