What is Index Fund – MoneyPerception

What is index fund? Index fund is a type of mutual fund. The manager of an index fund doesn’t try to pick stocks to beat the market. Instead, he tries to build a stock portfolio similar to a stock market index.

Example of index fund

For instance, an index fund can be built to track the S&P 500 Index. So the fund has 500 stocks, and the percentage of value of each stock holding to the whole fund is similar to that of the S&P 500 Index. The performance of the index fund will be very similar to the S&P 500 Index. If the S&P 500 Index performs very well, the fund also performs very well. If the S&P 500 Index has a bad year, the fund also has a bad year.

Why do we need index fund?

Before we have index fund, when people want to invest in mutual fund, the only option is actively managed fund, where the fund manager spends lots of time and resources to select stocks to beat the market. However, not every actively managed mutual fund can beat the market. In fact, lots of them don’t. Some investors feel difficult to know which fund will beat the market. So now we have the index fund. Here is the idea: “if we can’t beat them, let’s join them.” The fund no longer tries to beat the market. Instead, the fund tries do exactly the market does. Because the index fund doesn’t spend resource on stock research, the expense is lower. So you get a low cost fund, with performance similar to the market as a whole, which is better than that of some actively managed funds. In theory, the index fund’s performance should be exactly as the index it tracks. But in reality, usually there is a small difference. It’s often too difficult and expensive to make the fund portfolio exactly same as the index all the time. Initially, index funds were used to track indexes representing the whole stock market, such as S&P 500. Later some index funds are developed to track an index for a specific sector, such as technology stocks.

Compare index fund with actively managed mutual fund – pros and cons

Why you may want to invest in a index fund – Pros

  1. The expense of an index fund is typically lower than that of an actively managed mutual fund, because the former doesn’t need to perform stock research.
  2. The performance of an index fund is actually better than that of many actively managed mutual funds.
  3. Some indexes don’t change the stock selection very often, so the index funds may have low turnover, which may lead to low taxes.

Why you may not want to invest in a index fund – Cons

  1. Some actively managed mutual funds have good records to beat the market for long periods. If they can continue to do so, your return to invest in these funds may be meaningfully better than that of the market as a whole, even after the expense is deducted.