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Index funds explained
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December 7, 2001: 11:00 a.m. ET
What's an index fund?
By Walter Updegrave
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NEW YORK (CNN/Money) - Could you please explain in layman's language what index funds are?
I can try. Index funds are nothing more than portfolios of stocks that are designed to track as closely as possible the returns of a stock-market index or benchmark. How do they do this? Simple. Instead of frenetically buying and selling stocks as most mutual fund managers do, index fund managers hold all or nearly all of the stocks in whatever benchmark they're tracking. In fact, you could even argue whether one ought to apply the name "manager" to a person who runs an index fund. There's no judgment about which stocks to buy. The manager buys the stocks in the index and pretty much holds them unless the fund must sell shares to pay cash to a fund owner who's redeeming shares.
Mention index funds to most investors and they probably think of funds that track the Standard & Poor's 500, an index made up of large-company stocks that account for roughly 80 percent of the value of all publicly traded U.S. stocks. That's because the Vanguard 500 Index fund is one of the oldest (date of birth: 1976) and largest (recent assets: nearly $90 billion) index funds. But in fact, you can find funds that mirror dozens of indexes.
For example, there are ones designed to track the Dow Jones Industrial Average, an index of 30 large stocks that, despite its name, includes not-exactly-industrial issues like McDonald's; the Russell 2000, which consists of 2000 small-company stocks; and the Wilshire 5000, an index made up of virtually every publicly traded stock in the U.S. (This index, by the way, now contains more than 6,000 stocks, but retains the 5000 in its name because that was the original number in the index).
You can even find indexes for specific sectors of the market (utilities, technology, financials, etc.) for different countries (anyone up for an index of Brazilian or Malaysian stocks?) and for different investment "styles," such as growth (companies that are expected to have rapidly growing profits) or value (companies that may be undervalued on the basis of their earnings power or assets).
Why invest in an index fund?
Okay, so now that you know what index funds are, you're probably wondering why someone would want to invest in them rather than in an "actively managed" fund -- that is, a fund where a money manager is applying his or her judgment to find the best securities. Well, one reason is that index funds have low costs. There's no big fee for a money manager and research staff to go out and beat the bushes for the best stocks. And since there's less trading in an index funds, transaction fees are also much lower than in most other funds.
Index funds also tend to be "tax efficient" -- which is investment-speak meaning they typically generate their gains in ways that allow you to shelter more of your return from the IRS. Finally, over long periods of time, index funds typically provide higher returns than their actively managed counterparts, in large part because of their lower costs.
No investment is without its drawbacks, however. You should know that index funds provide no protection in a falling market. If, for example, you own an index fund that tracks the S&P 500 and the S&P 500 falls 20 percent, then your index fund will also drop 20 percent or so, no ifs, ands or buts. Add up index funds' advantages, however, and I think they're an ideal way for individual investors to harness the power of the stock market.
While I wouldn't go so far as to say one should never own actively managed funds -- I own several -- I would say that most individuals should seriously consider making one or more index funds a core holding in their portfolio. Before you join the millions of investors who've already discovered the benefits of indexing, however, you may want to learn a bit more about the fundamentals of indexing strategies by checking out the IndexFunds University, a site that can tell you more than you ever wanted to know about index funds. 
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