Index Fund Definition
An index fund is a type of mutual fund with a portfolio designated to match or track the components of a market index.
How To Invest in Index Funds
Firstly, it is important to know that investing in index funds, or “indexing,” is a form of passive fund management. Consequently, this means that instead of choosing securities to invest in and strategize their buy and sell periods, you want to create a portfolio that mimic the securities of a particular index – this is the either the entire stock market, such as the S&P 500, or a broad segment of it. By mirroring the profile of the index, the fund will follow and match its performance. Knowing this, the goal is to not exceed the index’s performance, but to match it.
Index Funds vs. Mutual Funds
Although an index fund is a type of mutual fund, the two have different goals and consists of different strategies. While index funds aim to match the market’s performance, mutual funds aim to outperform it. Therefore, because index funds want to mimic the securities of a particular index, they are a form of passive investment, while mutual funds are a form of active investment as investors choose the securities. Furthermore, because index funds are matching the market, the performance is relatively predictable over time, while mutual funds have much less predictable returns.
Also, investors tend to have higher returns with index funds over long periods of time, therefore, investing in index funds is recommended to save for retirement. On the other hand, mutual funds have higher returns in shorter periods of time. Lastly, mutual funds typically have higher fees than index funds.
Are Index Funds Safe?
Index funds are considered safer than investing in individual stocks. This is because index funds are low risk and less volatile as they are highly diversified, meaning they consist of a wide variety of stocks. Additionally to its high diversification, they have lower fees and the average return is about 10% annually. A downside is that although index funds are considered safer than other forms of investing, they can limit your exposure to investment strategies elsewhere that could potentially be successful.
Examples of Index Funds
Some examples include:
- Standard and Poor’s 500 Index (S&P)
- This is the most well known, consisting of hundreds of the largest, globally diversified American companies from every industry.
- Russell 2000
- An index of 2,000 small-cap companies
- Nasdaq Composite
- An index of over 2,500 companies listed on the Nasdaq stock exchange
- MSCI EAFE
- An index of mid- and large-cap foreign stocks from Europe, Australasia, and the Far East.
- Wilshire 5000
- A total market index of all American-stocks actively traded in the U.S.