Index Funds - Mutual Funds

An index fund is a real mutual fund which is designed to duplicate the performance of an index. Index funds are tied to a tracking index, such as the S&P 500 by holding, in the same proportion, all the stocks held by the index. Index funds are often managed directly by computerized models which are set up to follow a particular index, and make decisions regarding sale and purchase of stocks, in order to track the index. This is also referred to as passive management, indicating that the fund needs little human intervention, which in turn means reduced fund management fees for investors. While in theory this is a sound idea, the reality is that the performance, costs and fees associated with index funds vary depending on the model used and the efficiency of the supervising financial organization.

A much debated discussion is ongoing regarding the relative merits of index funds and active managed funds. One would think that a professional fund manager should be able to spot, and offer to investors, great stocks which consistently outperform the market – Thus making the debate regarding active vs. passive management a moot affair. However, an important factor which tilts the balance towards index funds is time. Extensive surveys and studies have shown that most stocks do not out-perform the index over a significant period of time. That means that a stock may go up for some time, but at the end of the day, it will be pegged back to somewhere below the index.

Of course, the very concept of active management is knowing when to get rid of stocks which are about to tank. Since this article is not meant to be a primer on how to make a killing on the stock market, let’s just say that a lot of new investors get saddled with junk and watch their investments getting wiped out. This is where index funds provide a way to enter the market, while mitigating the risk, albeit over a lengthy period.

Please not that active managed funds can and do out-perform the index. It basically depends on the investment decisions made by the fund manager. This also means that active managed funds charge investors with higher fees to cover the operating costs and human involvement. Conversely, index funds charge fewer fees, but this is also a complicated issue which varies depending on the fund manager’s infrastructure and operating costs.

While you should consult with your financial planner before you invest in mutual funds, a combination of an investment in an index fund, along with a small amount set aside for an active managed fund might give you some personal insight into how each performs and what the exact costs are. That kind of first-hand knowledge you will not find in the books, or in a financial consultant’s office.