What Is an Index Fund?

[marla]

OK, I know I'm showing my ignorance here, but could someone explain in very simple terms what exactly an Index Fund is. I have a friend that keeps telling me that if I invest in the stock market, an Index Fund is what I should buy. I just don't understand what exactly that is. Thank you

[cmorus]

An Index fund is just a mutual fund that owns all the stocks in a particular index like the S&P, NASDAQ or Russell 2000. It's different than other mutual funds which are "actively managed" which means that there are employees who study different companies and decide which stocks they want to buy or sell and how much of each.

With an index fund, there's no management and hardly any trading because it mirrors the index. This means that the costs should be lower and the capital gains (and therefor your taxes), too.

Another type of "Index" to consider are Exchange Traded Funds. They are similar to Index Funds in that they mirror some index or other group. They trade like stocks so you can put stop/loss orders etc. on them. You always know what they trade at, too because you can look it up just like a stock. They aren't very good for small, regular investments though because each transaction will cost you.

The other great thing about ETFs is that there are a lot of them. For example, Emerging Nations, BioTech, Consumer, Small Cap, Large Cap, Value, etc as well as the S&P or NASDAQ etc.

I have a Biotech one for example, because I feel sure that there will be a lot of wonderful new medical products coming out in the next 20 years, but I haven't a clue which company will be successful.

Having an ETF or Index fund allows me to participate without as much risk. Of course, I don't have the possibility for some really blow out gains like I would if I owned a particular stock that did incredibly well. That's OK with me, I'd rather be a tortoise than a hare!

Cindy Morus

[marla]

Sorry for not being a very good student...this is all really new to me so excuse me if these questions are very basic.

Who decides what is in a index and how do you know what stocks are part of the index?

What is a stop/loss order?

It sounds like index funds are for people who want to buy stock in a certain area, but don't know enough about individual companies, so they buy a bunch of similar stocks so it isn't so risky. Is this correct?

Thank you for your help and I'm sorry if those questions are "obvious"

[terry1156]

Who decides what is in a index and how do you know what stocks are part of the index?

What is a stop/loss order?

It sounds like index funds are for people who want to buy stock in a certain area, but don't know enough about individual companies, so they buy a bunch of similar stocks so it isn't so risky. Is this correct?

I'm not an expert in this area, but I will try and answer your questions the best I can.

1. The idex funds are just groups of stocks that are placed together, usually because they meet a certain criteria. There are some quite famous ones like the S&P 500 (large stocks) and Russel 2000 (small stocks), but anyone can make up an index of stocks.

2. A stop/loss order is when you put a price on a stock so that if it goes down in value to a certain point, it will automatically be sold at the price you determine so that you don't lose even more money.

3. Yes, I think that is basically correct although there are other reasons why people like index funds.

[Tree0164]

Another reason people like index funds outside of their retirement plans is because there is not a lot of turn over in buying and selling so less capital gains taxes. Inside a retirement plan, doesn't make a difference since you don't get hit with capital gain taxes.

[kenneth.robert]

Originally Posted by terry1156

I'm not an expert in this area, but I will try and answer your questions the best I can.

1. The idex funds are just groups of stocks that are placed together, usually because they meet a certain criteria. There are some quite famous ones like the S&P 500 (large stocks) and Russel 2000 (small stocks), but anyone can make up an index of stocks.

2. A stop/loss order is when you put a price on a stock so that if it goes down in value to a certain point, it will automatically be sold at the price you determine so that you don't lose even more money.

3. Yes, I think that is basically correct although there are other reasons why people like index funds.

It will be risky to buy bunch of similar stocks.

[jIM_Ohio]

Originally Posted by marla

OK, I know I'm showing my ignorance here, but could someone explain in very simple terms what exactly an Index Fund is. I have a friend that keeps telling me that if I invest in the stock market, an Index Fund is what I should buy. I just don't understand what exactly that is. Thank you

Maria good question.

An index is an "average" which is used to track a given type of investment.

An index fund is a mutual fund which owns some or all of the securities the index tracks, in hopes of mimicing the index performance.

Indexing is known as "passive management", meaning the mutual fund buys what is in the index, in the percentages it makes up the index. The mutual fund will give average performance, because it is tracking an index which is giving the average for a certain portion of the market.

There are two types of index techniques

First is a fund could hold all the stocks which make up an index. The best example here is the S&P 500. The S&P 500 is an index which tracks the average performance of large companies. Most S&P 500 mutual funds will own all 500 companies in the index, in the percentages the company makes up the index (meaning Microsoft, GE and a few others will be weighted higher than a smaller company like Kodak or Ford). The fund won't own 499 or 501 stocks- it will own exactly 500, and it will be the 500 defined for the index. if a stock is removed from the index (like when Enron went bankrupt), then the stock is removed and replaced with whatever S&P replaced it with in the index.

The other indexing technique is sampling. This means the index fund will buy some of the stocks in the index, but not all. The mutual fund will attempt to mimic the index (still an average) by buying some of the stocks in the index, but not all. Many, many examples of this exist. Russell 2000 index, Wilshire 5000 and Wilshire 4500 indexes would all be difficult to own every stock in the index (Wilshire 5000 actually has 5700 stocks in the index, Wilshire 4500 is the Wilshire 5000 without the S&P 500 stocks in it). A Wlshire 5000 index fund (usually called total market index) will probably own around 4000 stocks. It's just not prudent for a fund manager to hold every stock in the index. The purpose of using an index like this is to track the average of the total market (75% of which is the large cap S&P 500 anyway). So adding the additional 3500 stocks to get the other 25% of the market isn't going to change the average much by adding that 3501 stock.


I avoid index funds, so take the next several comments with a grain of salt.

Who decides what is in the index- GREAT question. In the case of the Wilshire 5000 or 4500, a fund manager somewhere had to decide what to remove, yet the fund is considered passive.

The S&P 500 is decided by a committee at Standard and Poors (S&P). The committee has no vested interest in picking the 500 companies. They don't pick the 500 biggest, or the 500 best, or the 500 fastest growing. They choose 500 stocks which are supposed to be a proxy for averaging the market as a whole.

Like I said before, 75% of the total market of 5700 stocks is controlled by the 500 stocks in the S&P 500. Meaning 75% of the movements of the total market are dictated by the stocks in the S&P 500. they do a decent job picking, but when a company like Enron is in the index, all index funds need to hold this stock until the committee removes it from the index.

Index funds are cheap- maybe expenses of .15%. You can find cheap managed funds as well, but a cheap managed fund is .6%. A managed fund means someone is in charge of picking stocks for the fund. In my case I choose funds which might buy 125 of the 500 stocks in the S&P 500. I pay more (.6%) for a person to be paid to make these decisions. But when Enron went down and took the index with it (index returned -10% in 2000), my managed fund increased 13% in same year. My fund manager could pick the good ones and remove the bad ones. He's been doing it for 25 years.

There is more on my blog on this.

[Scanner]

Sorry you asked? LOL.

Yeah, it's basically a "non-biased" committee. The "index" is supposed to be representative of what it should look like.

For instance, "Large Cap." When the average person thinks large cap, they think "retail", like Dell, Pepsi, Walmart. . .but there orthers too that the committee can zone in on - Catepillar, DuPont, Tyco, etc.

I guess they also decide how to deploy the "large caps". . .for instance, how much does "banking" get a representation? 10%? 20%? Pretty important. . .because I bet Countrywide was in the Large Caps and probably still is.

On the subject of ETF's, they are an interesting animal because they represent a "basket" (instant diversification) of stocks, bonds, real estate or commodities.

They are instantly diversified but not necessarily indexed.

I own SLV. . .which is basically just a basket of raw silver bullion.

I have been watching ICF. . .which is basically a basket of real estate.

They are rather complicated though. . .just because I buy shares of SLV or ICF, the manager doesn't automatically go out and purchase more silver or real estate - the basket remains fairly consistent. They may only add or subtract 1x/year.

In a mutual fund, the mutual fund manager is obligated to go buy whatever the mission statement of the fund is when you send in $100.

I guess as a rule, most ETF's do track an index though. . .but I am not certain it's mandator y.

[jIM_Ohio]

If we are dealing with the term index- the index itself cannot be invested in. It is a benchmark used by media and analysts to measure performance.

A mutual fund or ETF can mimic (follow) the index. There will be tracking error and error because of fund/ ETF expenses.

A person can choose a portfolio of stocks, but calling that "creating an index" is not truly real (what will they measure performance against).

I check to see if my managed funds beat the S&P 500- especially my large cap and mid cap funds. I also check my small cap, mid cap and large cap funds vs the Wilshire 5000.