Index funds are mutual funds that track a stock or bond index. Index funds buy all of the securities in an index, or a representative sample of it, thus providing about the same performance as the index they are tracking, minus fund expenses. In other words, index funds earn approximately the market rate of return. If stock prices rise, index fund performance (i.e., the value of index fund shares) will rise accordingly. The opposite is true, however, if stock prices plummet. In this case, the share prices of index funds will fall. Index funds have been in existence since 1976 when the fund known today as the Vanguard 500 Index Fund was launched.
An index is an unmanaged collection of securities whose overall performance is used as an indication of stock or bond market trends. Examples of indexes include the widely-reported Dow Jones Industrial Average or DJIA, which tracks 30 large companies; the Standard & Poor’s (S&P) 500, which tracks 500 large U.S. companies; the Russell 2000, which tracks small companies; the Wilshire 5000, which tracks almost every listed U.S. stock; and the Lehman Aggregate Bond Index, which mirrors the performance of U.S. bonds.
There are also indexes that track the performance of foreign securities. Among the most widely quoted is the Morgan Stanley Capital International EAFE (MSCI EAFE) index. EAFE is an acronym that stands for “Europe, Australasia, and Far East” and the EAFE index is used to track the performance of international stocks much like the S&P 500 is used as a benchmark for American stocks.
In both bull (rising) and bear (declining) markets, index fund returns beat those of many actively managed (non-index) mutual funds. One reason is that index funds have relatively low turnover, which helps keep taxable capital gains distributions and trading costs low. Turnover is the frequency with which stocks and bonds are traded in a mutual fund portfolio.
Due to their low turnover, some index funds have expense ratios (expenses as a percentage of a mutual fund’s assets) of 0.2 (one fifth of one percent), compared to an average expense ratio of 1.5% for actively managed funds. Over time, this difference in fund expenses can really add up and provides index funds with a significant and ongoing performance advantage.
Below are some recommendations about index funds provided by investment experts:
Many people select actively managed funds because it is human nature to want to believe that there are “wizards” who can quickly grow your money. It is often impossible, however, to determine whether a fund manager’s superior performance was due to skill or luck. With index funds, you know what you’re investing in and you can regularly track the benchmark index on which your fund is based.