What are index funds? As their inventor, Vanguard founder Jack Bogle puts it, they are a way to be the market -- not beat the market.
Unlike most mutual funds, which are made up of a collection of investments hand-picked by human advisers, index funds are bags of stocks assembled by computer models to mimic a broader market.
Indexes can be designed to reflect almost any type of market, ranging from a tight focus on financial stocks or utility stocks, for example, to a broad measure of the entire stock market.
Some of the most popular broad-based indexes are: the Wilshire 5000, which mimics the performance of more than 7,000 US stocks; the S&P 500, which tracks the largest US stocks; and the Russell 2000, which tracks the smallest. Other indexes can track international markets.
Advantages of Index Funds
- Low expenses: Index funds are cheap to run and cheap to own because human managers are only minimally involved. Trading costs also tend to be lower in an index than they are in a fund in which the managers are frantically buying and selling. In general, the only trades an index makes are to adjust the fund to fit its index or to meet owner redemptions.
- Easy diversification: There's no need to carefully select stocks from a wide array of industries with a broad-based index fund. A single share in an S&P 500 index, for example offers exposure to more than 70% of the US stock market.
- Performance: About 75% of actively managed funds fail to beat the performance of the S&P 500 index in any given year, partly because they are weighed down by expenses and partly because even the best money managers find it difficult to make the right picks every year.
Disadvantages of Index Funds
- Bubble reflection: Indexes like the S&P 500 are weighted to give a more prominent role to companies with the largest total stock values. So when tech stocks soared to the moon in the bubble of the late 1990s, index funds also loaded up on them -- just in time for the bust.
- Opportunity lost: By definition, index funds are average performers. Only human managers -- including yourself -- have a chance to beat them. And some managers do, particularly if their performance is measured over a long period of time.