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An index fund is a type of passively managed mutual fund that seeks to track the performance of a benchmark market index such as the S&P 500.In theory, this could be achieved simply by holding all of the investments represented by the index, in the same proportions as their representation in the index. In practice, however, actual index funds depart from exact indexation in several ways:
- keeping some assets in cash to cover redemptions;
- using a large representative sample of index components instead of all of them;
- actively managing a small portion of the portfolio in the hope of compensating for transaction costs, which would otherwise cause the fund's performance to fall slightly short of the index.
There are a number of advantages and disadvantages to investing in an index fund. Over time, index funds have outperformed the average actively-managed fund in the equivalent asset class . That is, some actively-managed large-cap funds may beat the S&P 500 index, but the average large-cap fund does not. Another advantage is a lower expense ratio; by using a public index to determine the makeup of a fund, fund managers can forgo expensive research costs. (However, the trademark owners of the well-known indexes can and do charge index funds a stiff fee for their use of the the trademarked name). Index funds also tend to incur lower capital gains taxes, as they generally hold securities for longer terms than more aggressively managed funds.
One of the key disadvantages of index funds is that the components of an index tend to change infrequently. This can potentially expose the fund to greater risk in a sudden downturn. Furthermore, since index funds are designed to track broad swings of the stock market rather than collecting individual stocks that "beat the market", they may not be ideal for short-term investors.
1 Origins of the index fund
In 1951, John C. Bogle, then a student at Princeton University, wrote a senior thesis entitled: "Mutual Funds can make no claims to superiority over the Market Averages." In 1973, Burton Malkiel published his book A Random Walk Down Wall Street which presented academic findings for the lay public. It was becoming well-known in the lay financial press that most mutual funds were not beating the market indices, to which the standard reply was made "of course, you can't buy an index." Malkiel said, "It's time the public can." Partly in response to Malkiel, Bogle founded The Vanguard Group in 1974, and on December 31, 1975, the Vanguard Index Trust became the first index fund ever offered to the public. The fund exists today under the name "Vanguard 500 Index Fund."
2 See also
- Exchange-traded fundExchange-Traded Funds (or ETFs are a type of closed-end mutual fund. Essentially, ETFs are mutual funds that trade on the stock market. As such, they offer features of a mutual fund in a stock-like instrument. Just like mutual funds, ETFs represent a coll
- Index investingIndex investing also called indexing is a method of investing whereby a fund (or individual) buys the same stocks in the same proportions as in a target index. The objective of this method is to buy and hold the index. The idea is that technical analysis
- Mutual fund
- Stock market index
FinanceFinance is the application of the principles of financial economics to an inter-related set of monetary problems. Its aim is in the optimal use of financial instruments. In the case of a company, this generally involves balancing risk and profitability an
