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Why an Index Fund Can Be a Good Investment

There are many different types of mutual funds. The list narrows significantly if you only consider index funds. There are also a number of different types of index funds to choose among, but the list is smaller. A beginner can make good choices or bad choices, but if that person chooses a fund that is designed to emulate the performance of one of the better known stock or bond indices, the choice will most likely be a safe one.

What is an Index Fund?

An index fund is an investment fund that typically consists of a portfolio of special stocks or bonds. These stocks or bonds are chosen to yield a return similar to a particular market index. The performance of that market index should be indicative of the performances of the stocks or bonds that index tracks. An index fund might be assembled to track the performance of the Standard and Poor's index of the 500 leading stocks on the New York Stock Exchange. Such a fund could be a mutual fund containing shares from all 500 companies, but more likely would be made up of a sampling of perhaps 15 or 20 stocks chosen from the 500. Most index funds are, by their very nature, mutual funds since they are composed of shares of stocks or corporate bonds from a number of different companies or institutions.

What Are the Different Types of Index Funds?

The answer is somewhat open-ended as, by definition, an index fund is designed to track a market index, and there are any number of market indices that can be defined. The more common investment funds are designed to track such indices as the Standard and Poor's 500, the Dow Jones Industrial Average (DJIA) that is made of 30 blue chip stocks, the Russell 2000 Index, or the NASDAQ 100 Index. You could invest in a fund that tracks the U.K. Stock Exchange or the Japanese Stock Exchange. Some of these funds are created to track specific sectors in the economy such as the financial sector, the aerospace sector, or the pharmaceutical sector.

Does the Security and Exchange Commission Regulate Index Funds?

The Security and Exchange Commission (SEC) does not regulate the content of the indices, but would oversee the funds that are designed to track a particular index. For example, if you were to put together a mutual fund designed to follow the performance of the aerospace sector and added bank stocks or municipal bonds to lessen the risk an investor might face, that fund may or may not qualify as an index fund. You could, however, select 10 of the 30 stocks that make up the DJIA and definitely call that an index fund. The SEC wants to see that the content of any investment fund matches the description given to that fund. The Commission also monitors how various funds are managed, and how shares in those funds are traded.

What Are Some Advantages of Investing in an Index Fund?

One advantage is that if one of these funds is built around a sector that is relatively stable, investing in that fund should carry less risk. Another advantage is that the content of the funds themselves tends to be relatively stable. These types of funds are sometimes categorized as passive funds. There is usually not a lot of buying and selling shares within a given fund at any one time. Changes to a fund are most likely to be made if its performance begins to deviate from the performance of the index it is supposed to be following. These types of funds tend to have lower fees and expenses associated with them since managing them can be relatively straightforward. These funds are often recommended for beginning investors as they tend to be safer and less volatile than is the case with many other mutual funds.

What Are Some Disadvantages in Investing Your Money in These Funds?

The main disadvantage these funds have over other types of mutual funds is that by their very nature they are less flexible. If the stock market as a whole takes a nose-dive, your Standard and Poor's index fund or your NASDAQ index fund is likely to follow suit. The management of other types of mutual funds can be more nimble at such times as stocks in a weakening sector can be jettisoned, and more promising stocks or bonds can be incorporated into a fund. This could make investing in funds built around indices poor choices for the short term. On the other hand, since over a long period of time the stock market tends to move in an upward direction, so should most index funds.

Index funds generally carry less risk than many other types of mutual funds. Investing in them might even seem boring. In the investment world, however, boring is often a good thing. Whatever fund you choose, you should always read the fund's prospectus before investing in it. Doing a bit of comparison shopping when choosing among mutual funds is also advisable. You will be told again and again, but sometimes in small print, that past performance is no guarantee of future returns. Believe it.

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