Index funds are usually mutual funds or exchange-traded funds. Index funds track an index, which is like a cross-section of the market. Some funds invest in all the stocks, bonds, or other investments within the index. Others choose a representative sample.
Index funds stand in contrast with actively managed funds. In an active fund, one or more expert investment managers use their own judgment or calculations to pick and choose what investments to buy and sell.
Here are how the differences between the two break down:
|Actively managed funds
|Match the market
|Beat the market
|Copy the index by buying the same investments in the same proportions
|Use research and analysis to try to pick specific winning investments
|Often charge very low fees because copying an index doesn’t take much work
|Tend to charge higher fees because active management takes more research (and often more trading)
|Good to know
|Won’t ever perform much better than average and will always lose when the market does
|Can gain much more or lose much more than the market
Although all index funds track an index, what they invest in can vary widely:
Index investing is popular. That’s largely because index funds charge lower fees and have better long-term track records than most active managers. However, they still come with trade-offs:
|They’ll always do about as well as the market.
|They’ll never do much better than the market.
|They’ve delivered better results, on average, than actively managed funds over the long term.
|They’ll lose money when the market does and can’t do anything to stop those losses.
|They’ll never do anything crazy—like make a big bet on a stock that turns out to be a loser.
|They’re kind of boring (i.e., a superstar stock picker like Warren Buffett will never run them nor will they invest in the next big thing).
“Both large and small investors should stick with low-cost index funds.“
Index funds are collections of securities (such as stocks and bonds) that try to match the performance of a specific index. Some funds buy all the securities in the index, while others pick a sample. Index funds are popular because they can offer broad diversification and low costs, but an index fund will basically never perform better than the market index it tracks.