What Is An Index Fund?

You hear a lot of talk about index funds in the investment world. But just WTF an index fund exactly?

Below, we look at what an index fund is, the types of index funds and whether you should invest your cashola in them.

Before we answer the question “what is an index fund” we have to answer the question “what is a mutual fund”?

A mutual fund is a type of investment that pools the money from a bunch of investors to invest in stocks, bonds and/or other assets.

When you invest in a mutual fund that focuses on stocks, the fund uses your money (and the money from other people who invest in that mutual fund) to purchase stocks.

If the stocks in the mutual fund’s portfolio, increase in value overall, the value of your mutual fund shares go up. If they go down, the value of your shares go down.

Capiche? Groovy.

With that understanding, let’s get to the question “what is an index fund”?

An index fund is a mutual fund that owns assets that match (track) a specific market index.

For example, if you buy an index fund that tracks the S&P 500 Index, the index fund will own shares of all the stocks that are in the S&P 500. And you can expect the returns of that index fund to closely match the returns of the S&P 500 Index.

Index funds are very similar to ETFs. You can learn about them and how they are different from index funds here.

Types of Index Funds

You can find index funds that track all types of market indexes including…

Broad market index funds – track major indexes like the S&P 500, NASDAQ or Dow Jones Industrial Average.

Index funds that track specific classes of stocks – US Value, Growth, Large Cap, Small Cap, etc.

International index funds that track the various overseas market indexes like Japan’s NIKKEI or the Europoean FTSE.

Sector index funds that track the companies in a specific industry like tech, finance or health care.

Bond index funds that invest in a mixture of short, intermediate and long term bonds.

Are Index Funds a Good Investment?

For a lot of people, absolutely! Index funds make an excellent investment. (There’s a reason why the grand poobah of investing, Warren Buffett, recommends investors put their money in index funds.

Here are some of what makes them so appealing…

Low costs

Index funds tend to have very low expenses associated with them (especially when compared to actively managed mutual funds). And that’s a big deal. Cuz the less you pay in fees, the more your investment can grow over time.

Less volatility

If you buy individual stocks, you can see wide swings in your investment. Which can make many investors as stressed as a long-tailed cat in a room full of rocking chairs. Index funds, however, tend to be more stable and, over time, almost always increase in value.

Diversification

Your investment in an index fund gets spread out to a number of stocks and/or bonds. This is an easy way to diversify your investment holdings.

Performance

The dirty little secret about investing is that even pros get it wrong. Like A LOT.

Over time, you’ll find index funds tend to outperform mutual funds managed by hotshot investing gurus. It’s nice to beat the market, but most pros won’t. No matter how many fancy degrees they have.

By investing in an index fund, you’ll be able to at least match the performance of the market over time. Which, again, is almost always up with a long enough time horizon.

Simplicity

Don’t have the time, interest or whatever to spend on investing? Index funds are your friend! You don’t have to do a lot of research or active management of index funds. It’s a simple investment you can pretty much set and forget for years at a time.