Index fund

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An index fund, also known as an index tracker, is a type of collective investment scheme that aims to replicate the performance of a specific market index. These funds can be structured as mutual funds or exchange-traded funds (ETFs) and are designed to provide investors with broad market exposure, low operating expenses, and low portfolio turnover. Index funds achieve this by either holding all of the securities in the target index in the same proportions as the index itself or by using statistical sampling to hold "representative" securities that mimic the index's performance.

Overview[edit]

The primary objective of an index fund is to match the investment returns of a particular market index. Unlike actively managed funds, where fund managers make decisions on which securities to buy or sell, index funds passively track the performance of an index. This passive management strategy results in lower operating costs and, consequently, lower expense ratios for investors.

Operating Mechanism[edit]

Index funds can employ different strategies to track the performance of their target index:

  • Full Replication: The fund holds all the securities in the index in the exact proportions as they appear in the index.
  • Statistical Sampling: The fund holds a subset of securities that statistically represent the broader index. This approach is often used for indices with a large number of constituents or when full replication would be impractical or costly.[1]

Advantages of Index Funds[edit]

  • Broad Market Exposure: Index funds provide investors with exposure to a wide range of securities, offering diversification benefits and reducing individual security risk.

Low Costs: Due to their passive management approach, index funds typically have lower expense ratios compared to actively managed funds. This cost efficiency is achieved by minimizing research and trading activities.

  • Transparency: The holdings of an index fund are a direct reflection of the securities in the target index, making it easy for investors to understand where their money is invested.

Expense Ratios[edit]

The expense ratio of an index fund, which measures the fund's operational costs as a percentage of its assets, can be significantly lower than that of actively managed funds. Index funds can have expense ratios as low as 0.18%, while actively managed funds may have expense ratios exceeding 3.0%. This difference in costs can have a substantial impact on long-term investment returns.[2]

Passive Management[edit]

Index funds are considered passive investments because they do not attempt to outperform the market. Instead, they aim to replicate the market's performance. By accepting the market prices set by active investors, index funds can significantly reduce the costs associated with investing.[3]

Popular Indices for Index Funds[edit]

Several market indices are commonly used as benchmarks for index funds, including:

  • Russell 2000: Tracks the performance of approximately 2000 small-cap companies in the United States.
  • DJ Wilshire 5000: Represents the total stock market by covering nearly all publicly-traded companies in the U.S.
  • MSCI EAFE: Focuses on foreign stocks from Europe, Australasia, and the Far East, providing exposure to international markets.
  • Lehman Aggregate Bond Index: Covers the total U.S. bond market, including government, corporate, and mortgage-backed securities.[4]

References[edit]

  1. Index Fund. Wikipedia.
  2. Index Funds. About.com.
  3. Are Index Funds Eating the World?. The Wall Street Journal.
  4. Index Fund. Investopedia.