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What Is An Index Fund?

What Is An Index Fund?

An index fund is a mutual fund which seeks to mirror the diversification and performance of a broad-based index such as the S&P 500, NASDAQ 100, Wilshire 5000 or Russell 2000. By basing stock purchases and quantities relative to an underlying index it allows the mutual fund to minimize expenses related to active trading as well as mimic performance of historically proven indices. Index mutual funds come in a few varieties such as pure indexes and enhanced indexes which seek to match identical performance or slightly modify the formula to increase returns respectively. Enhanced index mutual funds implement strategies which benefit from limited market timing and major economic events.

The primary purpose of an index fund is to maintain principal, minimize risk and replicate historical performance of popular indices. An index fund is great for individual investors who have an investment strategy of buy-and-hold. Long-term investment horizons in the decades benefit most from these types of mutual funds because they are more likely to have consistent annualized returns closely matching the overall market. Index funds implement a set it and forget it stock picking strategy because the index being modeled doesn't change frequently. This lack of active trading minimizes investment related expenses lowering mutual fund operating costs and employing fewer staff members.

Many mutual funds, especially ones which are actively traded and have 200% to 300% portfolio turnover, not only have higher expenses but often have below average investment returns. It is not unheard of for well-known mutual funds with billions of dollars under management to have a loss for the year while a number of stock market indices have positive returns. This is because human beings, no matter how educated or experienced, will never be able to time the market or pick stocks with 100% certainty. Active trading by "professional" portfolio managers doesn't guarantee better performance but it does guarantee higher expenses and often mediocre returns.

Under federal law mutual funds are required to make capital gains distributions at the end of every fiscal year. Mutual funds which are more actively traded often result in higher capital gains distributions which means more taxes paid by investors. Index funds on the other hand have little to no active trading and therefore pay out significantly less in capital gains. This not only lowers the tax burden for individual investors but it also means more money remains in the mutual fund allowing it to grow faster over a longer period of time. It has also been shown statistically that index funds perform better than actively managed funds by a significant amount.

Index funds are not limited to the various indices of domestic stock markets and large cap corporations. There are many different types of indices which can have their basis in the bond market, foreign stocks, technology sector and small cap stocks. An investor doesn't have to sacrifice overall return or choice when investing in an index mutual fund. After the boom years of actively managed load based mutual funds in the 80s and 90s, index funds came into their own as a low-cost high quality alternative. They are often recommended by financial planners and investment advisors due to their stability and superior returns over the long term. An index fund can be an integral part of a diversified investment portfolio for individual investors planning for the future.

Image by: Brett Jordan