An index fund is a mutual fund that tracks an index, usually the S&P 500, though there are others. An index, as an example, is the S&P 500a list of about 500 stocks that are used to measure the overall performance of the NYSE (New York Stock Exchange). The purpose of an index fund is to perform as close as possible to the index it mimics (tracks); so and gains and losses tracked in the index will translate to gains or losses for the fund.
The Expense Ratio:
The first thing an investor might notice about an index fund is the costs associated with it. Every mutual fund has its own strategy for how it selects its investments, and this strategy is generally orchestrated by a fund manager. While there is no inherent problem with an active approach to fund management, the activity behind these funds costs money and as such, an actively managed fund costs more. The expense ratio of a mutual fund varies and represents a percent portion of the assets on an annual basis is used to operate the fund. By nature, an index fund requires very little in the way of active management, and as such carry a lower than average expense ratio. While an actively managed fund may possibly outperform an index, an index fund has no such potential since it is “passively” managed.
In addition to the expense ratio, some mutual fund families might charge small account fees or transaction fees for index fund account with less than a certain balance. While this is not an expense ratio, and fees paid in any capacity should be considered a loss. An investor should consider whether or not a possible fee is worth it, and if not, either increase the investment a balance or find another fund family where they can purchase the fund for free.
Regardless of whether or not the mutual fund is an index fund, the first thing a potential investor must consider is how appropriate the fund is in light of their goals. The investor’s ability to stomach the risks a fund carries and the amount of time they have to keep the money invested are imperative in deciding which mutual fund may be appropriate. For an index fund, this will determine which index an investor should seek to track. For example, an S&P 500 index fund would be appropriate for an investor who can tolerate the risks associated with a mutual fund that invests in stocks, while an investor who is concerned with the performance of the stock market may consider a less volatile investment like a bond index fund.
Since an index fund is simply copying the investments of an index, it’s much cheaper to operate. Index funds can have expense ratios of 0.05% or sometimes lower (or higher). This decrease in expenses translates to an increase in potential returns and vice versa. Essentially, the expense ratio affects the performance of the fund.
The expense ratio is important, but the purpose of an index fund is twofold: To track an index and to reduce expenses. It makes sense, then, to select an index fund with a low expense ratio, but as the saying goes you get what you pay for. It’s true that index funds are cheaper to operate, but they still have a job to do: To track the performance of an index. How close or far away from the index’s holdings is called tracking error. An index fund with a large tracking error is no index fund at all.
Consider with an index fund is a combination of the expense ratio and the tracking error. In the case of an index fund, cheaper may not be better, but do your homework on the fund. The tracking error and expense ratio can usually be found on the website of the fund family from which the index fund originates.