Index funds are portfolios that are designed to track, but not necessarily outperform, an underlying benchmark index. They typically replicate the benchmark’s portfolio in its entirety, investing in the same components in the same percentage allocations. In theory, the only real difference between the performance of an index fund and its underlying benchmark should be the expense ratio the fund charges to operate.
The most popular index funds tend to cover the S&P 500, but indices such as the Russell 2000 and the Dow Jones Wilshire 5000 index are also commonly used.
Index Mutual Funds vs. Actively Managed Mutual Funds
The goal of most actively managed funds is to produce a return that exceeds its benchmark over time. Active funds look to invest within the parameters of the fund’s mandate, but are under no obligation to invest in any specific security. For example, a large-cap value fund will invest primarily in the market’s biggest companies that are relatively undervalued, but can generally invest as much as it wants in any company within that definition.
Index funds, on the other hand, are designed to simply follow a benchmark. In this way, they are great vehicles for providing investors with exposure to a specific sector or market without veering too far off course pursuing above average returns. Index funds also tend to be a bit more transparent than active funds since their composition tends to change relatively little over time. Active fund managers have the ability to turn over significant chunks of their portfolios quickly. Many active funds only publish their holdings every quarter.
Be sure to also check out our Guide to the Turnover Ratio.
The Benefits of Index Fund Investing
Perhaps one of the biggest advantages of index funds is that they have made investing simple and cheap for the average investor. Investing can be intimidating and confusing for many individuals. They feel like they can be easily taken advantage of by a broker and may never even know it. In many cases, index fund investing typically requires no financial professional involvement and no fees to open an account. It’s easy for anyone to set up a simple portfolio often with just an application form and a check.
Other advantages of index funds:
- They are easy to use. Most require just a one-time application to open an account.
- Most are broadly diversified owning hundreds of securities.
- Many have razor-thin expense ratios and carry no transaction fees.
- With little trading inside the portfolio, index funds tend to be especially tax efficient.
Many index mutual funds offer additional flexibility by providing ETF counterparts. For example, Vanguard offers the Vanguard S&P 500 ETF along with the Vanguard 500 Index Fund. The advantage of an ETF is that it allows intraday trading, whereas most mutual funds price only once at the end of the day. Many ETFs also come with a lower expense ratio that their corresponding mutual fund.
For ETF alternatives to passively managed mutual funds, be sure to check out the Mutual Fund to ETF Converter tool on our sister site, ETFdb.com.
Some of the Biggest Index Mutual Funds
Vanguard is generally considered the most popular index fund provider in the industry, so you’ll find many of the largest index funds there. Here are some of the largest index mutual funds.
Index funds have perhaps been the single biggest development in the investing industry. They have brought investing to the masses and do so at a fraction of the cost of most brokers and actively managed funds. Most investors can now successfully build broadly diversified long-term portfolios only using index funds, while keeping costs low and flexibility high.
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