Understanding Index Funds

To understand index funds, you must first understand what a stock market index is.
A stock market index is a list of stocks whose combined performance is tracked by investors as an indication of the health of a particular portion of the economy. Even people who know little or nothing about the stock market have heard of some of the more famous indexes and the companies they track—for example, the Dow Jones Industrial Average, the oldest and best-known index, tracks the stocks of 30 of America’s bigger, more famous firms, including American Express, Coca-Cola, Walt Disney, McDonald’s, and Wal-Mart Stores.
The value of the Dow is calculated by combining the share prices of all 30 companies according to a special formula. As the values of these companies rise and fall, the Dow rises and falls with them.
Because the Dow reflects the performance of the stock of only 30 companies, it can’t accurately reflect the diversity of the entire U.S. economy — much less the world economy. So over the years, other indexes have been invented by various financial companies, each mirroring the performance of a different group of stocks:

• The Standard and Poor’s (S&P) 500 Index: Tracks the performance of some 500 large U.S. companies. S&P 500 is often referred to as a “broader” index than the Dow because it’s more inclusive and therefore reflects more general trends in American industry.
• The Wilshire 5000 Index: Tracks virtually the entire U.S. stock market.
• The Russell 2000 Index: Tracks smaller, fast-growing companies.
• The Morgan Stanley Select Emerging Markets Index: Tracks companies in developing regions of the world, such as South America, Southeast Asia, and Eastern Europe.

An index fund is a mutual fund that buys the stocks contained in a particular index. For example, the Vanguard Index Trust — the first index fund, founded in 1976 — owns shares of all the companies in the S&P 500. The investment objective of an index fund depends on the index being followed. A broad index reflects changes in the overall economy, which usually moves more gradually than any single business sector. Thus, a broad index is usually less volatile than a more narrow one; and so, in general, the broader the index, the more conservative the fund. Index funds are available today based on every popular stock market index.
As you may imagine, managing an index fund is less challenging than managing most other fund types. The manager of an index fund is simply charged with buying and selling stocks to match those contained in its index. This style of fund management is sometimes called passive investing. By contrast, other funds are run by managers who must constantly make independent investment decisions; this is known as active investing.
Because passive investing calls for less complicated managerial decisions, the cost of running an index fund is less than with other fund types. Thus, investors in index funds generally incur lower management fees.
In general, index funds perform well; in fact, the majority of funds that are actively managed actually grow less quickly than such broad indexes as the S&P 500! “Beating the indexes” isn’t an easy challenge, even for a highly skilled professional money manager. So index fund investing has become a particularly popular choice among investors who want to enjoy some of the strong growth possible in the stock market while minimizing the risks that go with active management. Because passively managed funds trade less often than actively managed funds, index funds generate less capital gain income than most other funds.