Index funds, either in the form of mutual funds or exchange-traded funds, are popular investment choices for new investors and those looking to stay in the market for the long term. This type of investment can offer instant portfolio diversification at a minimal cost as compared to buying individual securities. Diversification, a standard in sound investing, is especially easy to achieve by choosing a broad market index fund, that is one that covers several hundred or thousands of stocks or bonds. Index fund strategies are similar across the market and each fund's prospectus will outline the specific investment objectives of management.
Understanding Index Funds
Index funds are often called passive investments because there is not much active turnover in the underlying assets. Because of this low turnover rate of assets within index funds, management fees are usually lower than actively managed funds. Over time, this reduction in fees and expenses adds to the net return of investing in this type of fund. It has been shown that index funds do as well and often better than actively managed funds, which are ones where the management tries to beat the market through active trading. Investors can take advantage of the diversification and solid returns on index funds through purchasing shares in mutual funds and exchange-traded funds.
In the February 1, 2009, edition of Economics and Portfolio Strategy, a publication written for institutional investors, Mark Kritzman, president and CEO of Windham Capital Management of Boston, published the findings of a study on how index funds compare to actively managed funds. Kritzman found that index funds consistently outshine both hedge funds and actively managed ones in net returns.
Index funds holding stocks or bonds try to match the results of a market benchmark. For example, Fidelity offers a bond index fund, specifically the Spartan U.S. Bond Index Fund, with a minimum of 80 percent of the assets in bonds that are part of Barclays Capital U.S. Aggregate Bond Index. There are no transaction fees charged to Fidelity customers for purchasing shares of this fund. Broad-based ETFs also follow index fund strategies by purchasing and holding assets that mirror a market benchmark. For example, the iShares Russell 3000 Index Fund is an ETF that uses the Russell 3000 Index as a benchmark, tracking 3,000 stocks. Index fund strategies are not always an exact mirror of the market benchmark. For example, suppose XYZ Corporation makes up 1 percent of an index a particular fund is following. Management thinks that XYZ is more valuable than other stocks in the index. Therefore, in our hypothetical index fund XYZ is given a 3 percent weight in the fund. Strategies like this are one reason returns on index funds do not always exactly match the return of the benchmark.
Federal tax treatment of short-term capital gains can take a bite out of active-trading profits. Index funds generally hold the securities for the long term, thereby bypassing the higher tax rate of short-term gains as compared with the tax on long-term gains.
Vicki A Benge began writing professionally in 1984 as a newspaper reporter. A small-business owner since 1999, Benge has worked as a licensed insurance agent and has more than 20 years experience in income tax preparation for businesses and individuals. Her business and finance articles can be found on the websites of "The Arizona Republic," "Houston Chronicle," The Motley Fool, "San Francisco Chronicle," and Zacks, among others.