Index Fund

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Definition: Index Fund


Index Fund

Quick Summary of Index Fund


An index fund is a portfolio of assets with allocation rules that remain fixed regardless of market conditions, commonly for the purpose of approximating the performance of some market index, such as the Russell 2000 Index. The index fund does not have to be linked to an existing index. Typically, an index fund is either a mutual fund or an exchange-traded fund (ETF). John Bogle of the Vanguard Group proposed the index fund concept in 1975. They issued the first index fund, which matched the composition of the S&P 500. An index fund tends to have significantly lower fees and expenses than an actively managed fund because of its passive management style. Taxes are also reduced because less trading lowers realized capital gains for the index fund. Consequently, the typical index fund has outperformed the average of comparable actively managed funds by more than Bogle had originally anticipated. Even legendary fund manager Peter Lynch has stated that in most case an actively managed fund provides “no advantage” over an index fund.



Video Guide For Index Fund




Full Definition of Index Fund


An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio designed to replicate or track the components of a financial market index, such as the S&P 500 Index (S&P 500). Index mutual funds are said to offer broad market exposure, low operating expenses, and low portfolio turnover. These funds adhere to their benchmark index regardless of market conditions.

Index funds are widely regarded as ideal core portfolio holdings for retirement accounts such as IRAs and 401(k)s. Warren Buffett, the legendary investor, has recommended index funds as a safe haven for retirement savings. Rather than picking individual stocks for investment, he believes that the average investor would benefit more from purchasing all of the S&P 500 companies at the low cost of an index fund.

  • An index fund is a stock or bond portfolio that is designed to replicate the composition and performance of a financial market index.
  • Actively managed funds have higher expenses and fees than index funds.
  • Index funds are invested in using a passive strategy.
  • Index funds attempt to match the market’s risk and return on the theory that the market will outperform any single investment over the long term.

How Index Funds Work

The term “indexing” refers to a type of passive fund management. Instead of actively stock picking and market timing—that is, selecting securities to invest in and strategizing when to buy and sell them—a fund portfolio manager builds a portfolio whose holdings mirror the securities of a specific index. The idea is that by mimicking the index’s profile—the stock market as a whole, or a broad segment of it—the fund’s performance will match that of the index.

For nearly every financial market, there is an index and an index fund. The most popular index funds in the United States track the S&P 500. However, several other indexes are widely used, including:

The Wilshire 5000 Total Market Index is the largest equity index in the United States.

  • MSCI EAFE Index, which includes stocks from Europe, Australasia, and the Far East.
  • The Bloomberg U.S. Aggregate Bond Index, which tracks the entire bond market.
  • Nasdaq Composite Index, comprised of 3,000 Nasdaq-listed stocks4 Dow Jones Industrial Average (DJIA), comprised of 30 large-cap companies
  • For example, an index fund tracking the DJIA would invest in the same 30 large and publicly traded companies that comprise the index.

Index fund portfolios only change significantly when their benchmark indexes change. If the fund is tracking a weighted index, its managers may rebalance the percentage of different securities on a regular basis to reflect the weight of their presence in the benchmark. Weighting is a technique for balancing the impact of any single holding in an index or portfolio.

Actively Managed Funds vs. Index Funds

Purchasing an index fund is a type of passive investment. Active investing, on the other hand, is realised in actively managed mutual funds, which have the securities-picking, market-timing portfolio that managers described above.

Cost Savings

The lower management expense ratio is one of the primary advantages of index funds over actively managed counterparts. The expense ratio of a fund, also known as the management expense ratio, accounts for all operating expenses such as payments to advisors and managers, transaction fees, taxes, and accounting fees.

Index fund managers do not require the services of research analysts and other stock-selection experts because they are simply replicating the performance of a benchmark index. Index fund managers trade their holdings less frequently, resulting in lower transaction fees and commissions. Actively managed funds, on the other hand, have larger staffs and conduct more transactions, raising the cost of doing business.

The additional costs of fund management are reflected in the expense ratio of the fund and are passed on to investors. As a result, low-cost index funds frequently cost less than 1%—0.2% to 0.50% is typical, with some firms offering even lower expense ratios of 0.05% or less—in comparison to the much higher fees charged by actively managed funds, which typically range from 1% to 2.50%.

Expense ratios have a direct impact on a fund’s overall performance. Actively managed funds, with their often higher expense ratios, are automatically at a disadvantage to index funds in terms of overall return and struggle to keep up with their benchmarks.

Check your online brokerage account’s mutual fund or ETF screener to see which index funds are available to you.

Better Profits

Passive funds, according to supporters, have outperformed most actively managed mutual funds. Indeed, the vast majority of mutual funds fall short of outperforming their benchmark or broad market indexes. According to SPIVA Scorecard data from S&P Dow Jones Indices, approximately 75% of large-cap U.S. funds generated a return less than the S&P 500 over the five-year period ending Dec. 31, 2020.

Passively managed funds, on the other hand, make no attempt to outperform the market. Instead, their strategy seeks to match the market’s overall risk and return, based on the premise that the market always wins.

Over time, passive management that results in positive performance is more likely to be true. Active mutual funds perform better over shorter time periods. According to the SPIVA Scorecard, only about 60% of large-cap mutual funds underperformed the S&P 500 in a year. In other words, roughly two-fifths of them outperformed it in the short term. In addition, actively managed money rules in other categories. Over the course of a year, for example, more than 86 percent of midcap mutual funds outperformed their S&P MidCap 400 Growth Index benchmark.

Index Funds in the Real World

Index funds have been in existence since the 1970s. Passive investing’s popularity, the appeal of low fees, and a long-running bull market all conspired to send it soaring in the 2010s. Investors poured more than $400 billion into index funds across all asset classes in 2021, according to Morningstar Research. Actively managed funds experienced $188 billion in outflows during the same time period.

The original Vanguard fund, founded in 1976 by Vanguard chairman John Bogle, remains one of the best in terms of overall long-term performance and low cost. In terms of composition and performance, the Vanguard 500 Index Fund has closely tracked the S&P 500. Vanguard’s Admiral Shares had an average annual return of 7.84 percent as of June 2021, compared to 7.86 percent for the S&P 500. The expense ratio is 0.04 percent, with a $3,000 minimum investment.


Index Fund FAQ's


How do index exchange-traded funds (index ETFs) work?

Index funds can be set up as exchange-traded funds (ETFs). These products are essentially stock portfolios managed by a professional financial firm, with each share representing a small ownership stake in the overall portfolio. The financial firm’s goal with index funds is not to outperform the underlying index, but rather to match its performance. If, for example, a particular stock accounts for 1% of the index, the index fund’s manager will attempt to replicate that composition by allocating 1% of its portfolio to that stock.

Do index funds have fees?

Index funds do charge fees, but they are typically much lower than those of competing products. Many index funds charge less than 0.20 percent in fees, whereas active funds frequently charge more than 1.00 percent. When compounded over longer time periods, this difference in fees can have a significant impact on investors’ returns. One of the main reasons index funds have become such a popular investment option in recent years is because of this.


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Definition Sources


Definitions for Index Fund are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 8th April, 2022 | 0 Views.