What is an Index Fund?
Recall than an Index is a statistical way of valuing and tracking a specific section of the economy.
Indices exist for tracking nearly every aspect of the economy. There are stock indices which track the U.S. stock market, the French stock market and the stocks of just energy companies. There are bond indices that track the U.S. treasury market, the German bond market or Corporate the bond market. There are indices that track rates charged by shipping companies and indices that track almost anything else that you can imagine.
Perhaps the most well known stock index is the S&P 500 Index. This index is made up of 500 large American companies’ stock price. This index is used by many economists to track the performance of the general stock market. However it is just one of many stock indices that exist.
As an investor, you can not invest directly in an index; however there are index funds which are made to track a specific index.
Shown above is a chart of the S&P 500 index, currently around 1800. However, you can not buy a “share” of the S&P 500 index. Instead, in order to emulate the performance of the S&P 500 index, you would purchase shares in an S&P 500 index fund.
Below you can see a chart comparing the performance of the S&P 500 index to an ETF that is made to track the S&P 500.
This fund (Ticker symbol: SPY), is just one of many S&P 500 index funds available.
(For more funds that track the S&P 500, check out our Fund Spotlight Series on S&P 500 index funds, here: http://begintoinvest.com/begin-to-invest-fund-spotlight-series-sp-index-funds/)
An S&P 500 index fund will buy and hold stocks that exactly match the makeup of the S&P 500 index. Index funds are a type of “passively managed” investment, where fund managers are only trying to match an index.
This differs in comparison to actively managed funds which will invest their money in only specific securities within an index, trying to pick out the winners and losers to gain more than the general index.
It is very easy and inexpensive to invest in an index fund. Typical expense ratios are less than 0.1%. Compare that to many actively managed funds which charge expense ratios as high as 2%!
On average, over the long term individual investors and professional fund managers have struggled to match the performance of a simple index fund.
- Over the 23 years ending in 2009, actively managed funds trailed their benchmarks by an average of one percentage point a year.
- Only 9.7% of actively managed funds have beaten the S&P 500 Index 3 years in a row.
- 95% of actively-managed bond funds underperformed their indexes for the 10 years leading up to 2007.
Why are index funds gaining so much popularity for do it yourself investors today? Not only can they be more tax efficient, easier to manage and cheaper (in terms of an expense ratio)…they also tend to outperform!
Looking to trade out some of your actively managed mutual funds for a passively manage index fund? Check out our Fund Spotlight Series for ideas: