Index funds are mutual funds that try to duplicate the performance of a particular index such as the Dow 30 Industrials or the S&P 500 for stocks, or the Lehman-Brothers Aggregate Bond Index for bond index funds. They do this by buying and holding all of the stocks (or bonds) that make up the selected index in the same percentages as the index.
There are index funds for every type of investor. A few examples are index mutual funds for large or small company stocks, international stocks, growth or value stocks, treasury or corporate bonds, even real estate index mutual funds.
This type of investment is ideal for the person who wants to invest in the stock or bond market, but lacks the time or patience to research individual stocks or bonds. Investing with index funds is also perfect for anyone who does not have a lot of money to invest at one time. Many index mutual funds have a low minimum initial investment and allow you to add small amounts periodically.
One of the biggest advantages of index mutual funds is that they usually beat about 80-85% of funds actively managed by professional money managers. This has been proven over time and is one of the main reasons many people invest in index funds.
A second major advantage is their low expenses. Since computers do most of the work in managing the fund, there is no need for a highly paid fund manager or research analysts. The best index funds typically have expense ratios as low as .18%, in comparison to actively managed funds which can have expense ratios over 3%.
In fact, because most funds tracking a particular index should produce similar results, the expense ratio is one of the most important things to look for when choosing an index mutual fund. After all, lower the expenses means more money in your pocket.
A third big advantage of index mutual funds is that they are very tax efficient. Since they don’t trade often, but instead hold their investments for the long term, they don’t generate a lot of capital gains which have to be paid out to their investors. And, because any capital gains which are paid out are usually long term gains, the tax rate on these gains is lower. So you get to pay less to the taxman. Trading costs are also lower since the stocks or bonds which make up the funds are not traded as often as an actively managed fund.
Finally, it is fairly easy to get information on which fund meets your investment needs since you can easily find a list of the best index funds in magazines such as Money Magazine or Forbes, or by checking one of the many online investment sites. Most large mutual fund companies like Vanguard, T. Rowe Price, and Fidelity have their own websites to highlight their own index mutual funds, as well as independent investment discussion sites like the Motley Fool.