Index fund: Meaning (information, definition, explanation, facts)

An index fund is a type of mutual fund that seeks to track the performance of a benchmark index such as the S&P 500. In theory, this could be achieved simply by holding all of the investments represented by the index, in the same proportions as their representation in the index. In practice, actual index funds depart from this slightly. Typical departures include: keeping some assets in cash to cover redemptions; using a large representative sample of index components instead of all of them; and actively managing a small portion of the portfolio in the hope of compensating for transaction costs, which cause the fund's performance to fall slightly short of the index.

There are a number of advantages and disadvantages to investing in an index fund. The chief advantage of this type of fund is that typically index funds perform better than the average actively-managed fund in the equivalent asset class. That is, some actively-managed large-cap funds may beat the the S&P 500 index, but the average large-cap fund does not. Another advantage is lower expense ratio; by using a public index to determine the makeup of a fund, fund managers can forgo expensive research costs. Index funds also tend to incur lower taxes, as they generally hold securities for longer terms than more aggressively managed funds.

One of the key disadvantages of index funds is that the components of an index tend to change infrequently. This can potentially expose the fund to greater risk in a sudden downturn. Furthermore, since index funds are designed to track broad swings of the market rather than collecting individual stocks that "beat the market", they may not be ideal for short-term investors.

Origins of the index fund

In 1951, John C. Bogle, then a student at Princeton, wrote a senior thesis entitled: "Mutual Funds can make no claims to superiority over the Market Averages." In 1973, Burton Malkiel published his book A Random Walk Down Wall Street which presented academic findings for the lay public. It was becoming well-known in the lay financial press that most mutual funds were not beating the market indexes, but the standard comment was, "of course, you can't buy an index." Malkiel said, "It's time the public can." Partly in response to Malkiel, Bogle founded The Vanguard Group in 1974, and on December 31, 1975, the Vanguard Index Trust became the first index fund ever offered to the public. The fund exists today under the name "Vanguard 500 Index Fund."