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What is an Index Fund?

As a type of mutual fund, an index fund is a professionally managed investment that is like a basket holding securities such as stocks or bonds. Index funds are designed to replicate a particular market index, such as the S&P 500, in an effort to match its returns as closely as possible, minus a small administrative expense. They are known to most investors for their low cost and broad market exposure.

How do index funds work?

Unlike traditional mutual funds, index funds are not actively managed. They are based on the concept that, over the long term, no one can accurately predict the future in order to earn greater returns than the market. The securities in index funds are not consistently added, removed and traded under a fund manager’s discretion. Instead, they attempt to hold the same securities in the same proportion, or market capitalization, as the indexes they track. For example, an index fund that tracks the S&P 500 contains the same percentage of shares of the index’s 500 companies.

Since index funds don’t carry the expenses of an active fund manager, from sales commissions to trading costs, they charge much lower fees than actively managed funds. In addition, research has shown that the majority of active fund managers tend to underperform their benchmarks, even before fees.

Why index funds may be right for your portfolio

Index funds have several potential benefits that help investors meet their long-term goals. Here are some key reasons why index funds may be right for your portfolio:

  • Their lower costs, compared to active funds, allow investors to keep more of their return – a difference that adds up over time
  • Since they attempt to match the holdings of a broad-based index, index funds provide greater diversification, which can reduce risk
  • Because of low turnover, index funds generate realized capital gains less frequently
  • As replicas of published indexes, index funds are highly transparent, so investors know exactly what is inside

Index funds can be found in just about every asset class. Therefore, the potential benefits of index funds can be captured in any part of your portfolio.