What it is:

Index funds are mutual funds that are designed to track the performance of a particular index .

How it works/Example:

When an investor purchases a share of an index fund, he or she is purchasing a share of a portfolio that contains the securities in an underlying index. The index fund holds the securities in the same proportion as they occur in the actual index, and when the index decreases in value, the fund ‘s shares decrease as well, and vice versa. The only time an index buys or sells a stock is when the index itself changes (either in weighting or in composition). Index funds have ticker symbols and are traded on all major exchanges.

The performance of an index fund usually does not exactly match the actual index’s performance. This is because index funds charge management fees, which eat into returns, and because the fund’s weighting in particular securities may not perfectly match the weighting of the securities in the actual index. The degree to which the fund and the index returns differ is called tracking error .

Why it Matters:

Index funds are a popular way to participate in the stock market and diversify a portfolio. Index funds have several major advantages over direct ownership of the underlying securities. Here’s a brief review:

Diversification — Each index fund represents an interest in an underlying basket of securities. This allows investors to gain broad exposure to a large group of companies easily. This diversification also makes index funds much less volatile than individual securities. Foreign index funds in particular make diversifying abroad less difficult and expensive; they also offer exposure to entire foreign markets and market segments.

Low Cost — Buying and selling shares of an index fund is far less expensive than separately buying and selling a basket of underlying shares. Also, the decision of which securities to invest in is determined by the index rather than by active management. This is why index funds usually have minimal expense ratios and are often more affordable than other diversified investment vehicles. However, many have minimum investment requirements and front- or back-end loads. making them impractical for some investors.

Liquidity — Index fund shares are bought and sold on major exchanges every day, and many funds trade hundreds of thousands (and in some cases millions) of shares per day. Buying and selling shares of an index fund can be faster and more convenient than buying and selling the underlying shares.

Dividends — Many index funds pass through the accumulated dividends paid by their underlying stocks. Over time, these dividends can add up to a significant sum.

Choices — Some index funds track broad U.S. equity market indexes. Meanwhile, others track specific sectors or industry groups. Still others represent an interest in baskets of foreign stocks. And finally, others invest exclusively in the bond market.

Returns — Studies have proven that over time, the average mutual fund typically fails to beat the broad indexes. With this in mind, index funds are a great way to capture broader-market returns. For adherents to the efficient market hypothesis, which states that it is impossible to outperform the broad stock market over the long haul, index funds can be a way to optimize portfolio returns.