An index fund is a collective investment scheme, very much like a mutual fund, where the goal is to mimic specific market indexes. One of the key aspects of a market index is its passive management. Index fund management is usually set by an algorithm with the goal being to maintain the index ratio.
The way that index funds are rated is based on their tracking error. The difference between the index performance and the fund performance is considered tracking error. The index funds that have the best success are the one’s that are able to gauge the index the best and have the lowest tracking error. One of the hallmarks of an index fund is that there is less risk involved than in traditional stock trading or mutual funds. Where as trading in the stock market and mutual funds is asset specific and usually involves a diversification of high and low risk investing an index fund will be highly diversified in all aspects of that individual market. It is very difficult to “lose one’s shirt” when investing in an index fund. In the alternative, the returns on investment are somewhat standardized and one can expect a certain return on their investment that will be low, but stable. There are many types of index funds. The most popular is trend indexing. Trend indexing involves the practice of owning a portion or representative collection of securities in the same ratio as the target index.
There are numerous advantages to investing in an index fund. Index funds are relatively inexpensive. Because index funds are managed passively they are do not need to employ expensive market analysts and stock brokers. As such, the expenses associated with index funds are relatively inexpensive in comparison to mutual funds and playing the stock market.
Index funds also have the advantage of being associated with low risk. Because the goal is to mimic the index itself, the index fund will be highly diversified so the failing of one aspect of the index will not have a catastrophic effect on your investment. In contrast, mutual funds and other specific investments are often security specific and the failing of one aspect of the fund can seriously affect the value of the mutual fund.
Index funds are also beneficial in considering turnover. A study performed over the last 16 years has shown that the return on an investment through a mutual fund is only 47% on the average whereas in a index fund that return is more like 87%.
There are disadvantages to an index fund. The goal of the index fund is to mimic the index itself. For that reason an investor will not run the high risk on his, or her, investment. In the alternative, the investor in an index fund will not receive a high return on his investment. It is very difficult to outperform the index and for that reason the return on the investment will be stable but low.
Another disadvantage is that the index fund sells and buys investments in the index fund based on when entities enter and leave the index. The S&P 500 has an annual turnover rate of between 1% and 9%.