Index Fund Definition

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. These funds follow their benchmark index no matter what the state of the markets is. 

Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts. Legendary investor Warren Buffett has recommended index funds as a safe haven for savings for the sunset years Rather than try to pick out individual stocks, he has said, it makes more sense for the average investor to buy all of the companies of the S&P 500 at the low cost an index fund offers.

"Indexing" is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing (that is, choosing securities to invest in and strategizing when to buy and sell them), he simply builds a portfolio whose holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well.

There’s an index, and an index fund, for nearly every financial market in existence. In the U.S, the most popular index funds track the Standard & Poor's 500 Index (S&P 500). But a number of other indexes are widely used as well, including:

• the Russell 2000 (small-cap company stocks)
• the Wilshire 5000 Total Market Index (the largest U.S. equities index)
• the MSCI EAFE (foreign stocks from Europe, Australasia, Far East)
• the Barclays Capital U.S. Aggregate Bond Index (total bond market)
• the Nasdaq Composite (3,000 stocks listed on the Nasdaq exchange)
• the Dow Jones Industrial Average (DJIA)

So, an index fund tracking the DJIA, for example, would invest in the same 30 large, publicly-owned companies that comprise that venerable index.

Portfolios of index funds substantially change only when their benchmark indexes do. If the fund is following a weighted index, its managers may periodically rebalance the percentage of different securities, to reflect the weight of their presence in the benchmark.

Investing in an index fund is a form of passive investing. The opposite strategy is active investing, as realized in actively managed mutual funds—the ones with the securities-picking, market-timing portfolio manager described above.

Lower Costs

One primary advantage that index funds possess over their actively managed counterparts: their lower management expense ratio. Since the fund managers of an index fund are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others that assist in the stock-selection process, as actively managed funds do. Because they trade holdings less often, index funds incur fewer transaction fees and commissions, too. In contrast, actively managed funds have bigger staffs and conduct more transactions.

The extra costs of fund management are reflected in the fund's expense ratio and get passed on to shareholders. As a result, cheap index funds often cost less than a percent (0.2%-0.5% is typical), compared to the much higher fees (typically 1% to 2.5%) actively managed funds command.

Since expense ratios directly impact the overall performance of a fund, actively managed funds with their often-higher expense ratios are automatically at a disadvantage to index funds, struggle to keep up with their benchmarks in terms of overall return.

Better Returns?

Which leads to performance. Advocates argue that passive funds have been successful in outperforming most actively managed mutual funds. It's true that a majority of mutual funds fail to beat broad indexes. For example, for the five-year period ending December 2018, 82% of large-cap funds generated a return less than the S&P 500, according to SPIVA Scorecard data from S&P Dow Jones Indices. Passively managed funds, on the other hand, do not attempt to beat the market. Their strategy instead seeks to match the overall risk and return of the market—on the theory that the market always wins.

That tends to be true over the long term. With shorter timespans, mutual funds do better. The SPIVA Scorecard indicates that in the course of one year, only 64% of large-cap mutual funds underperformed the S&P 500; in other words, over one-third of them beat it. And in other categories, managed money rules: for example, nearly 85% of mid-cap mutual funds beat their benchmark, the S&P MidCap 400 Growth Index, in the course of a year.

Even over the long term, when an actively managed fund is good, it's very, very good. Investor's Business Daily's "Best Mutual Funds 2019" Report lists dozens of funds that have racked up a 10-year average total return of 15% to 19%, compared to the S&P 500's 13.12%. They've significantly outperformed the market in one-, three-, and five-year periods, too. Admittedly, this a feat that only 13% of the 8,000 mutual funds out there can claim, the report says.

While index funds have been around since the 1970s, the popularity of passive investing, the appeal of low fees, and a long-running bull market have combined to send them soaring in the 2010s. For 2018, according to Morningstar Research, investors poured more than $458 billion into index funds across all asset classes. For the same period, actively managed funds experienced $301 billion in outflows. 

The one that started it all, founded by Vanguard chairman John Bogle in 1976, remains one of the best for its overall long-term performance and low cost. The Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and in performance, posting a one-year return of 9.46%, vs the index's 9.5%, as of March 2019, for example. For its Admiral Shares, the expense ratio is .04%, and its minimum investment is $3,000.