A stock market index is a measure of stocks in a segment of the stock market. An index fund is a mutual fund or exchange-traded fund (ETF) whose portfolio approximates the stocks in a stock index. The same company stocks are held by the index fund, and in roughly the same proportion, as in the stock index. Rates of return from index funds investing is similar to what would happen if a person could invest in the stock index itself.
Hypothetically, an index fund should follow the stock index and earn the same rate of return. In reality, there are fees that must be collected to pay the administrative costs of running a fund. While an index fund closely follows an index, the rate of return may differ slightly from the stock index. Since index funds investing is a passively managed portfolio, its fees tend to be minimal and are much less than actively managed mutual funds, resulting in lower costs and higher returns for investors. Fewer management decisions need to be made and fewer trades are exchanged, lowering capital gains taxes that are passed on to investors.
Traditional mutual fund managers actively manage a fund in an attempt to outperform the stock market by using skill and knowledge to choose stocks. Yet, managers are prone to make mistakes and can operate on faulty logic. Although it is possible to outperform the market for short periods, it is rare to beat the market for the long-term.
Index funds investing tends to outperform actively managed mutual funds over the long term because it eliminates manager errors. Manager turnover may also effect fund returns. With index funds, returns stay consistent during management transitions because returns are less dependent upon the manager’s performance.
An advantage of index funds investing is that the concept is easy for novice investors to understand. The possibility of making emotional decisions is reduced when an investor has confidence in the long-term performance of the index. Investors are also attracted by the increased rate of return due to lower fees.
Some of the most common benchmark indices are the Standard & Poor’s 500, which includes 500 of the biggest companies in the United States, the Wilshire 5000, which tracks nearly all of the US stock market, and the Russell 2000, which is a collection of 2,000 small-cap stocks. The Morgan Stanley Capital International (MSCI) tracks 1,500 stocks from around the world. Some companies are attempting to improve upon traditional indexing by utilizing new strategies and altering the proportions of companies in a fund based on various criteria.