An index fund is an investment designed to match the performance of a specific stock market index. There are literally thousands of different stock market indices, but these three are arguably the most significant indices in use today:

  • Standard & Poor’s 500
  • NASDAQ Composite
  • Dow Jones Industrial Average

To understand what an index fund is and how it works, you first need to understand what a stock market index is.

What is a stock market index?

A stock market index is a numerical value that represents the performance of a specified group of securities. For example, when you hear a TV or radio newsperson say, “The NASDAQ closed at 5,500.95 today,” they are referring to the value of the NASDAQ Composite index, which is determined by how the stocks in the NASDAQ market performed that day.

A stock market index serves as an indicator of how the overall market is performing. It also helps to identify market trends which can influence when and how people invest their money.

Every stock market index has its own unique characteristics. For example, the NASDAQ Composite index is mostly made up of stocks from information technology companies.

Now that you know what a stock market index is, you are ready to learn what an index fund is.

What is an index fund?

An index fund, which is most commonly offered to investors as a mutual fund, is made up of a cross section of securities from a particular stock market index. Ideally, this will result in the index fund closely following the performance of the selected market index.

Many index funds are based on the most popular stock market indices. One highly recognized index fund of this type is the S&P 500 Index Fund, which is based on the Standard & Poor’s 500 market index.

Some index funds are based on commodities like precious metals, agricultural products, livestock, and energy products like oil and natural gas. There are also index funds based on specific industries like banking, insurance, consumer goods, transportation, and healthcare.

One type of index fund which has recently grown in popularity is a Socially Responsible Investing (SRI) fund. SRI funds consist of securities from organizations that work towards improving social issues, like preserving the environment and eliminating child poverty. Simultaneously, SRI funds do not include securities from corporations that are viewed as being contributors to social problems.

There are also index funds which are based on bonds. Bond market indices are like stock market indices, except for the bond market. Bond index funds are made up of a selection of government bonds, corporate bonds, mortgage-backed securities, and other investments from the bond market.

What are the advantages of index funds?

Index funds have become a popular investment in recent years, as they offer several advantages over other investments.

Index funds offer investors a simple way to own a diversified stock portfolio. Most financial experts agree that diversification is an important aspect of any investment strategy. With an index fund, investors only need to choose the stock market index that matches their desired balance of performance and risk. The securities in the index fund are automatically selected based on the market index being used, making life easier for the investor.

Index funds are referred to as low-management funds. One criticism of traditional mutual funds is that they are actively managed, meaning they require a lot of administrative overhead due to the constant trading of the securities in the fund. This typically results in mutual funds having high management fees which are passed down to the investors.

Index funds are passively managed, as they are built to mirror a specific market index. Because of this, index funds have lower management fees than traditional mutual funds, giving them a significant advantage over the life of an investment.

Index funds give investors the option to choose a market index that reflects their personal values, like the Socially Responsible Investing funds mentioned earlier. This is a significant benefit for people who want to invest their money in companies involved in eco-friendly technologies like alternative energy, while keeping their money away from corporations that are less representative of their social values.

How do I invest in an index fund?

Your personal bank is often the best place to start if you’ve decided to invest in an index fund. That said, practically every brokerage (E*TRADE and Ameritrade are examples) offers a large selection of index funds to choose from. These firms let you open an investment account and purchase index funds directly online, making it very simple to invest your money accordingly.

Index funds are a smart investment

Index funds are flexible, high-performing investments that offer several options and advantages over traditional mutual funds and other stock-based assets. To get started with index funds, talk to your banker or visit an online brokerage and see for yourself how index funds can work for you.

Do you think you will invest in an index fund this year?

Posted by Aaron Axline

Aaron Axline is an author, technology journalist, blogger, and knowledge management expert.