What is an Index Fund?An index fund is a pool type investment (like a mutual fund or exchange traded fund) that tracks a given index such as the S & P 500, Dow Jones Industrial Average, or Russell 2000. The index that the fund tracks is called the benchmark, and the rate of return is basically the performance of the benchmark less any fund costs. Index funds can track stocks, bonds, or commodities. The way that the benchmark is tracked varies by fund. For example, a fund can hold all of the securities that make up the index in proportions as close as possible to the actual makeup of the index. Or the index could be sampled statistically and a representative basket of securities could be put together to represent the index. A passively managed fund is one that owns a representative collection of securities in the same percentages as the benchmark. The securities are held as closely as possible, and the makeup of the fund only changes when the index itself changes, so for example when a new corporation enters the S & P 500. Actively managed funds use so-called enhanced indexing. In this case, the fund is designed not to track the index accurately, but to beat it. In order to do this the fund must have an active portfolio manager or analyst who buys and sells securities in such a way to improve performance. Securities that are thought to outperform the average are overweighted, others will be underweighted or can even be excluded. Because of the active nature of the trading involved, costs are higher with this type of fund. An index fund can track domestic US stocks, sectors of the US stock market, foreign developed market stocks like Europe or Japan, emerging market stocks like China, Brazil, or India, or an index fund could track other types of securities like bonds.
Enhanced Index Fund (EIF)An enhanced index fund or EIF is a type of index fund designed to beat the return of the benchmark. An EIF is a mutual fund. In order to beat the benchmark, securities are overweighted, underweighted, or excluded as the fund manager sees fit. Leverage is often used to improve performance. These types of funds have higher costs, and can be more risky because of the use of leverage. There is a high turnover of stocks in the fund. In contrast, a passively managed mutual fund will hold stocks in proportion to the benchmark index, will have low turnover, is lower risk, and lower cost. However mutual funds have minimal investment requirements that may amount to several thousand dollars.
Exchange Traded Fund (ETF)An exchange traded fund is a stock. The shares of stocks are created by a management company that invests in a given asset, and then carves up ownership of the underlying asset into shares of stock, which are then traded on exchanges like the NYSE. So each share of an ETF represents a small proportion of ownership in the securities or assets used to make up the fund. For example, an exchange traded fund could track the price of gold. Whoever created the fund would purchase and hold a large number of ounces of gold bullion, then offer small slices of ownership as shares of stock. Exchange traded funds can track a stock index, bonds, precious metals, other commodities, or foreign currencies. Since exchange traded funds are equities, their price fluctuates throughout the trading day. The advantage of an ETF over a mutual fund are they trade like stocks so you can do things like short sell, you can buy as many or as few shares at a time as you'd like, you can buy and sell them at any time when markets are open, and costs are low because they follow the benchmarks as closely as possible (think of a passively managed mutual fund). While a mutual fund may require you to invest $3,000 just to get in the fund, you could buy a single share of an ETF for $100 or less, depending on the trading price. Many exchange traded funds are index funds that track benchmarks like the S & P 500. Below we provide examples of some exchange traded funds and mutual funds that are index funds of interest to investors looking for diversified portfolios.
iSharesiShares are index funds that trade as shares of stock on exchanges. There are iShares funds that track just about any index available for investors. Here are three samples to give you an idea of the types of investments available-listed by ticker. IYY-The Dow Jones US Index Fund. Seeks to track the price and yield performance of the Dow Jones Industrial Average. Holdings include Exxon Mobile, Microsoft, Proctor & Gamble, Apple, and General Electric, among others. IWZ-the Russell 3000 Growth Index fund. Tracks the Russell 3000 Growth index, with holdings such as Microsoft, Wal-Mart, Google, IBM, and Johnson & Johnson. IYE-Dow Jones US Energy Sector Index fund. Seeks investment results that correspond to US energy stocks like Occidental Petroleum, Exxon, and Chevron. AGG-Barclay Aggregate Bond Fund, seeks investment results that generally correspond to US investment grade bonds. Holds securities with AAA rating.
SPDRS Exchange Traded FundsSPDRS are among the most famous exchange traded funds. SPY-benchmark is the S & P 500. Fund has the goal of low turnover, low costs and accurate tracking of the index. Tracks SPTR, and is priced at approx. 1/10th the S & P 500. Holdings are the companies in the S & P 500, weighted as closely as possible to the actual index. EMM-benchmark is the Dow Jones Mid-cap Total Stock Market Index (DWMT). Holdings include Whirlpool, Kimco Realty, and Cliffs Natural Resources, among others. ELV-Dow Jones Large Cap Value Index (DWLVT). Holds large-cap value stocks like GE, Johnson & Johnson, AT & T, and Pfizer.
Vanguard Index FundsVanguard is a leader in low cost mutual funds. Typical initial investment requirement is $3,000. VFINX- The Vanguard 500 Index fund. Tracks the S & P 500 as closely as possible. Is considered relatively high risk compared to other Vanguard funds because its all in stocks. However, it has performed well historically and is the second largest mutual fund in existence. VGTSX-The Vanguard Total International Stock Index fund. Provides investors with exposure to both developed and emerging markets. VBMFX-The Vanguard Total Bond Market Index. With 92% invested in bonds (and about 6% in cash), this fund holds intermediate term bonds and tracks as closely as possible to an aggregate bond index.
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