How Do Index Funds Operate?
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The Composition of an Index Fund
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Index funds are a type of mutual fund composed of securities that are part of a major index, usually the S&P 500, the Russell 2000 Index, or the Wilshire 5000 Index. The index fund manager creates a portfolio of stocks based on risk and likely profits, aiming to replicate the return of the larger index. Usually, the fund manager isn't looking to outperform, but to closely mimic these profits.
The index fund itself may contain only a small sampling of the total selection of a given index, or may invest in every security available. All securities included in the index fund will be scrutinized and weighed for both long and short-term potential. However, index funds yield best with several years of steady growth and development.
Vanguard S&P 500: The First Index Fund
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The first index fund, the Vanguard S&P 500, was created by author and manager John Bogle in 1975. His reasoning was simple: "I projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per year in transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund."
Since then, most index funds, including Vanguard, have made a healthier profit than managed funds. With an average return of 17.3 percent compared to 13.9 percent for managed funds during the 1990s, Bogle's idea paid off handsomely for investors.
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Risks and Costs Associated With an Index Fund
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Index funds are often less risky than managed funds, and are good for investors who are just learning the ropes. Since actively managed funds are looking to outperform rather than parallel, the manager's choices can affect the returns. However, with many index funds so closely linked to the overall composition of a given index listing, it may be a little less fluid in regard to sudden losses.
Index funds usually cost less than actively managed funds since there's less supervision involved. There also isn't a cash reserve on hand, which leaves more money in the fund to earn a profit. The Motley Fool notes, "This practice [was] a very expensive penalty during the bull market of the 1990s."
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