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What is an Index Fund?

By Edited Nov 13, 2013 0 0

If you've ever invested money into the stock market then you've probably been bombarded with the names of different funds that you can invest in. These different funds (mutual funds) are the most common way for mom and pop investors to gain exposure to the equity markets, but there is another type of fund that your financial advisor probably has not, and will not, tell you about. This fund is called an Index Fund.

An Index Fund is simply a way for you to buy an equal weighting of all the stocks/equities that are listed on a particular index.

To make it easier to understand, think of the Dow Jones Industrial Average. The Dow is a compilation of 30 of the largest companies in America. It includes companies with household names such as Coca-Cola, Bank of America, Exxon Mobil, and AT&T, among others. If you were to buy a Dow Jones Index Fund, then you would be buying all 30 of the companies listed on the Dow Jones Average at a weighting equal to that of the Dow. Therefore, if the Dow goes up 1%, your investment will go up 1%. Your investment will track the movements of the Dow whether the direction is down or up.

You can do the same thing with the S&P 500, which is another popular American stock index. The S&P is comprised of 500 of the largest companies in America. It includes names such as Apple, eBay, and General Mills. (This is a full list of the S&P 500 companies.) If you bought an S&P 500 index fund, then you would own a portion of all 500 of the companies listed on the index. Incidentally, the S&P 500 is widely considered to be the best barometer of the health of U.S. stock markets, and many investors and mutual funds make it their goal to beat the S&P 500. This means that if the index rises 8% one year, then investors want to see their personal portfolios rise by more than 8%, thus "beating the market."

Unfortunately though, many mutual funds, and the mom and pop investors who own them, fail to "beat the market." There are two reasons that these mutual funds fail to beat the market:

  1. The fund managers may pick bad companies for their mutual funds, which then drags down performance.
  2. Managed mutual funds are more expensive, and after deducting the management costs, the mutual fund will underperform. Index funds often have very low expense ratios, some are even as low as 0.27% per year. Compare that to mutual funds which may cost 0.5-1% per year, as well as up front fees that can be as high as 5%. And remember, even after all of these fees and expenses, there is still no guarantee that you will beat or even match the market.

So why wouldn't your financial advisor tell you about index funds?

For the simple fact that index funds are inexpensive. We all want to believe that our advisor truly has our best interests at heart, and that he would never hold back valuable information from us, but that's not always the case. Most financial advisors make money through commissions, meaning that if they sell you an expensive financial product (like a mutual fund with a 3% up front cost), then they will make more money than if they had sold you an inexpensive financial product like an index fund. Unfortunately, many investors, and especially first time investors, don't even know that index funds are available, and therefore end up with high-cost mutual funds that under perform the broader markets.

This is not to say that all mutual funds are bad, but the good ones are getting harder and harder to find. The majority of mutual funds underperform the market and investors are usually better off by just asking for a low cost index fund.

 If you are unfamiliar with any of the terms used here, then be sure to check out these other articles:




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