Index Funds 101
An index fund is a mutual fund whose investment objective is to replicate the performance of a particular market index. This strategy of performing inline with the general market is a relatively safe, cost-effective approach to buying stocks. An investor is investing in the performance of the market rather than an individual stock.
An index fund attempts to achieve its objective primarily by investing in the securities (stocks or bonds) of companies that are included in a selected index. Some index funds also use derivatives (such as options or futures) to help achieve their investment objective. Some index funds invest in all of the companies included in an index; other index funds invest in a representative sample of the companies included in an index.
The basic premise supporting index funds is the idea of efficient market theory. This theory holds that people constantly seek to buy securities that will outperform the market. Competition is so effective and information so pervasive that a company's prospects translate into almost instantaneous stock price changes. Because of this inherent efficiency, it is very difficult to tell ahead of time whether a certain stock will do better than the general market. By creating an index fund that mirrors the entire market, investors avoid the inefficiencies of individual stock selection.
Advantages
There are some significant benefits in owning an index fund:
Cost
Index fund fees are lower than other types of funds. Because an index's composition is known and is easily replicated, it costs less to run an index fund. There's no need to pay a star portfolio manager to run the fund.
Ease of Use
While many mutual funds have specific investment strategies that require a skilled manager to implement, and a solid understanding of investing to feel comfortable with, and index fund is as basic as the index it attempts to replicate.
Turnover
When a fund manager decides to buy a stock and then sell it some time later, he turns over the stock. Because the general market index are generally stable for long periods of time, perhaps rebalanced only once or twice a year, the amount of stocks an index fund buys and sells is very low. This low turnover rate helps to reduce costs, as managers are charged for each trade they make as well as passing on capital gains taxes to fund owners.
Disadvantages
There are also some disadvantages to buying an index fund:
Non-active management
Because the investment objectives, policies, and strategies of an index fund require it to purchase primarily the securities contained in an index, the fund is subject to the same general risks as the securities contained in that index. In addition, because an index fund tracks the securities of a particular index, it may have less flexibility than a non-index fund to react to price declines in the securities contained in the index.
Performance
Because an index fund mimics market returns, it's impossible to outperform the general market. This said, an index fund des not always replicate performance perfectly. But an index fund should not underperform the market significantly. While fees for managing an index fund are much lower than other types of mutual funds, these management fees reduce the return to the investor relative to the index's actual return, though not by much.
Tracking Error
Tracking error is a problem with index funds. While the goal of an index fund is to "track" the performance of a specific index, attempting to do so can create some problems as managers attempt to eliminate tracking error, or the difference between an index's performance and the performance of the fund that tries to track it perfectly.
Whenever an index changes its holdings, an index fund must replicate those changes, selling the stock of those companies no longer in the index and buying shares of those companies added. As a result, the price of the stock removed from the index tends to go down. The price of stock added to the index tends to go up. The index fund, however, cannot keep pace because it sold a stock whose price was depressed and bought a stock whose price was inflated.
Here are two good places to research mutual funds and their performance:
