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What is an 'Index Fund'

An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. These funds adhere to specific rules or standards (e.g. efficient tax management or reducing tracking errors) that stay in place no matter the state of the markets. 

BREAKING DOWN 'Index Fund'

"Indexing" is a passive form of fund management that has been successful in outperforming most actively managed mutual funds. While the most popular index funds track the S&P 500, a number of other indexes, including the Russell 2000 (small companies), the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign stocks in Europe, Australasia, Far East) and the Barclays Capital Aggregate Bond Index (total bond market) are widely used for index funds.

Index Funds vs. Actively Managed Funds

Investing in an index fund is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund. Also, a majority of mutual funds fail to beat broad indexes, such as the S&P 500. Index funds are generally considered ideal core portfolio holdings for retirement accounts, such as individual retirement accounts (IRAs) and 401(k) accounts.

Since the fund managers of an index fund are simply replicating the performance of a benchmark index, they do not need the services of research analysts and others that assist in the stock selection process. Actively managed funds do need to utilize a research team. In these cases, the extra costs of fund management get reflected in the fund's expense ratio, and get passed on to shareholders.

Since expense ratios are directly reflected in the performance of the funds, actively managed funds and their often higher expense ratios are automatically at a disadvantage to index funds. As a result, many actively managed funds struggle to keep up with their benchmarks. For the five-year period ending in 2015, 84% of large-cap funds generated a return less than the S&P 500. In the 10-year period ending in 2015, 82% of large-cap funds failed to beat the index.

Warren Buffett

Warren Buffett recommended index funds as a safe haven for retirement. Rather than try to pick out individual stocks, he said it makes more sense for the average investor to buy all of the companies of the S&P 500 at the low cost an index fund offers. Cheap index funds often cost less than a percent, compared to the much higher fees active managers charge. The average index fund will perform well over time, the legendary investor has said, while most active managers will not. 

Funds Flows to Index Funds

With index funds outperforming their actively managed counterparts on a large scale, asset flows have grown significantly in index fund products. For 2017, investors poured more than $692 billion into index funds across all asset classes. For the same period, actively managed funds experienced $7 billion in outflows. 

Want to know more about index funds? Read Index Investing: Index Funds

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