DEFINITION: An index fund is an investment fund whose portfolio is designed to rise and fall with the stock market as a whole.
Whether taking the form of a mutual fund or an exchange-traded fund (ETF), an index fund attempts so far as possible to mirror the composition of a specific financial market index, such as the Standard & Poor’s 500 Index (S&P 500).
The primary objective of an index fund is to offer its investors broad exposure to the overall market, while requiring minimal intervention and thus operating expense.
By design, index funds always closely follow their benchmark index, regardless of current market conditions.
Index funds represent a form of passive investing, as opposed to the active investing pursued by portfolio managers that is characteristic of ordinary mutual funds.
ETYMOLOGY: The intellectual origins of the concept of an index fundextend to around 1960, when University of Chicago graduate students Edward Renshaw and Paul Feldstein published a paper exploring the idea in depth.[1] However, the concept was first put into practice and promoted by John C. Bogle beginning around 1975.
The English noun “index” is attested from the sixteenth century. It derives from the Latin noun index, indicis, meaning “informer” or “indicator.” The noun, in turn, is derived from the verb indico, indicare, “to make known,” “to show,” “to indicate.”
The English noun “fund” is attested from the seventeenth century. It derives from the Latin noun fundus, meaning “bottom” and, by extension, “bottom land,” “ground,” “soil,” “estate,” or, simply, “piece of property.”
USAGE: Index funds are generally held to be excellent assets for retirement accounts, including individual retirement accounts (IRAs) and 401(k) accounts.
Many highly regarded experts, including Warren Buffett, endorse index funds as a safe and solid basis for saving following retirement.
For the average retired investor lacking special financial expertise, it makes sense to take advantage of the convenience of purchasing all the companies in the S&P 500 through an index fund, as opposed to selecting individual stocks.
Buffett points out that for such investors, index funds represent a low-cost way of obtaining the security that comes with diversification.
Almost every financial market boasts an index—and with it, an index fund.
In the United States, the S&P 500 is the most popular index, which is why the index funds that track it are also the most popular.
Nonetheless, there are numerous other widely followed indexes, notably, the following:
- Wilshire 5000 Total Market Index: the largest US equities index
- MSCI EAFE Index: made up of foreign stocks from Europe, Australasia, and the Far East
- Bloomberg US Aggregate Bond Index: comprehensively tracks the total bond market
- Nasdaq Composite Index: consists of 3,000 stocks listed on the Nasdaq exchange
- Dow Jones Industrial Average (DJIA): comprises 30 large-cap companies
For instance, an index fund that tracks the DJIA would invest in exactly the same 30 large, publicly owned companies that constitute that index.
Index fund portfolios experience significant changes only when their benchmark indexes undergo significant movements, whether up or down.
In the case of a weighted index, fund managers may rebalance the proportions of different securities from time to time to match changes in the corresponding weights in the index serving as the standard or benchmark. (Weighting is a method of equalizing the impact of individual holdings within a portfolio.)
One significant advantage of index funds is a lower management expense ratio. Generally speaking, a mutual fund’s expense ratio—encompassing various operating costs such as advisor and manager fees, transaction costs, taxes, and accounting fees—is far lower in the case of index funds.
Since index fund managers seek to replicate the performance of a benchmark index, they do not need to employ research analysts and other professionals involved in the stock-selection process. For this reason, index fund managers are involved in fewer trades, resulting in lower transaction fees and commissions.
In contrast, actively managed funds must maintain larger staffs and conduct more frequent transactions, all of which leads to higher operational costs.
Note
1. Edward F. Renshaw and Paul J. Feldstein, “The Case for an Unmanaged Investment Company,” Financial Analysis Journal, 1960, 16: 43–46.