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Index FundsIntroductionThe securities markets have measurements to which you can compare your own securities. For example, you can consult the Standard and Poor's 500 Stock Index or the Dow Jones Industrial Average. These will give you an idea of how well your security is performing compared to the market "average." If you do not want to buy and sell to match the indexes, you can invest in a type of mutual fund that does your work for you. That is the subject of this section. We will cover these three topics: You have already guessed that these funds are called index funds. Read below to see how they operate.
How Index Funds Are StructuredAn investor wishing his or her investment portfolio to keep pace with the market should consider index funds. Simply put, these funds are made up of the securities that comprise major market indexes. They do not try to beat the market. Instead, they try to match it. An index fund that tries to match an index would hold the same securities that are in that index. The fund may weight the number of shares for each company it owns in proportion to the share price or company capitalization. For example, it may buy more shares of a company whose share price is lower than one with a higher share price. Alternatively, it may buy more shares of a large company than of a small company regardless of share price. The fund's prospectus describes the method of allocation. The fund may try to mimic the formula used in the index itself to achieve the same results as the index. Index funds require little to no active management. In most cases, computer-trading software dictates the portfolio allocation to match the chosen index. Buying and selling is infrequent because market indexes do not add or replace securities very often. As a result, portfolio turnover and management expenses are low. Some commonly used indexes include the S&P 500, Wilshire 5000, the S&P Midcap 400, the Russell 2000 and Lehman Brothers Aggregate Bond Index.
How Index Funds WorkInvestment markets are very complex. To build a portfolio of securities that consistently outperforms all other portfolios is virtually impossible. However, most portfolios do under-perform the indexes used to "measure the market." Since index funds own the stocks that make-up the index, they will perform as well as the market that the index measures. Most investors would like to boast about "beating the market." They hate to admit their portfolio did not even match it. Using an index fund gives the investor the best chance at least to match the market. However, if their index under-performs another index, their index fund can be expected to do likewise. The advantage of index funds is that they keep pace with the market. Their downside is that they cannot outperform the market. Some fund managers buy the top-performing stocks in the index instead of all the stocks in the index in an attempt to "beat the market." Such funds are not considered true index funds. Even Index funds that use the same index can be structured differently. Some allocate their holdings evenly among the index stocks. Others allocate a greater proportion to bigger companies than smaller ones. That is why different funds that use the same index have different returns. Their competitive returns and lower management fees have made index funds popular for years. Some other characteristics that appeal to investors will be discussed next.
Tax and Expense Advantages of Index FundsThe holdings in an index fund are not traded often because they are held to match an index. Most index funds are passively managed. Managers of actively managed funds, indexed or non-indexed, trade their securities more often. This results in capital gains and losses. When the fund has net capital gains, their shareholders must pay taxes on the capital gain distributions even if they are reinvested. Most index funds have little capital gain distributions subject to tax. Some investors think of this characteristic as a tax advantage. Since most index funds are managed passively, management expenses are lower compared to actively managed mutual funds. Two funds comprised of the same securities will perform the same. However, the one with lower expenses has an advantage.
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