What are Index Funds?
Index funds are mutual fund investments that mimic the performance of a particular market index. A market index follows a collection of financial securities that represent the performance of the market as a whole or a particular sector like bonds, international stocks or small cap stocks. Index funds attempt to reflect the market indexes which, in turn, attempt to reflect the financial markets. Investors buy index funds when they want their returns to reflect wider trends in the economy.
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Types
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There are several types of index funds. The most common ones mimic the holdings of the major stock market indexes. The Standard and Poor's 500 Index and the the DJ Wilshire 5000 follow the stock market as a whole. The Russell 2000 follows small company stocks. The MSCI EAFE follows international stocks in Europe and Asia. The Lehman Aggregate Bond Index follows the bond market.
Benefits
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Index funds are considered passive investments. There are no fund managers deliberately making investment decisions. Instead, securities are purchased to mimic indexes, and the market dictates its performance. There are some fees to pay for administrative costs, but they tend to be significantly lower than actively managed funds. This can save an investor a significant amount of money over several years.
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Potential
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Index funds outperform a majority of actively managed funds. This fact, combined with the lower management expense ratios, makes index funds popular with investors. Index funds tend to be longer term investments since investors are attempting to grow their portfolios with an expanding stock market. This results in lower share turnover. When investors buy and sell shares less frequently, the expenses can stay low.
Features
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Index funds purchase more of certain stocks in an index because of market capitalization. This is the market value of the company's outstanding shares. If a particular company's outstanding shares are worth twice as much as another company, the index fund will own twice as much of it. This means that index fund holdings are weighted more heavily in larger company stocks. The money is invested proportionately to the way money is invested in the market at large.
Considerations
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Investors should consider the pros and cons of index funds before investing in them. Index funds do well when there is a bull market and the stock market is growing. Index fund shares increase in value and the lower fees mean greater profits when the shares are sold. However, in a bear market, index funds are reduced in value the same as the indexes they follow. Since index funds are required to maintain holdings that reflect a particular index, they have limited flexibility to shift holdings to react to a market downturn.
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