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What Is an Index Fund?

Index funds are popular with those who want to take a slow-and-steady approach to investing. Brokerage firms that offer index funds are able to charge lower fees for index funds because they put fewer hours into managing them. Index funds don’t promise get-rich-quick results. Instead, they offer transparency and low cost to potential investors. Let us break it down for you.

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Index Funds: The Basics

An index funds tracks (or “indexes”) the stock market as a whole. Instead of having a well-paid guy or gal sitting on Wall Street choosing which stocks to buy, an index fund simply buys shares in many companies, aiming to track the overall performance of the stock market as closely as possible. With an index fund, the goal isn’t to “beat” the market. Index funds are passively managed because they sit there and go up and down with the market. They’re not actively managed by the aforementioned Wall Street folks.

The first index fund was started by John C. “Jack” Bogle, the founder of Vanguard. Vanguard still offers popular low-fee index funds, and Jack Bogle still touts their advantages. Index funds, says Bogle, consistently outperform their actively managed counterparts, and for a lower price. Intriguing, right?

Why Index Funds? 

So why are index funds popular if they don’t purport to beat the market? Well, index funds have a few things going for them that make them attractive to investors. For one thing, they charge lower fees than actively managed funds.

Index funds advertise their fees by listing their expense ratio. An expense ratio tells you the percentage of the fund’s assets that a brokerage uses to cover operational expenses. The lower the expense ratio, the more of your money you get to keep as an investor. Because index funds don’t have to pay as many people to manage the fund, they can afford to charge lower fees. That’s good news for the investor, since fees can eat into your investments.

What Is an Index Fund?

Another reason index funds are popular is that they’re diversified. Index funds track so many companies that they come with significant built-in diversification. More diversification means you run a lower risk that if one company (or sector) falls, your investments will fall along with it.

Index funds take care of some of the work of diversifying your investments. You don’t have to research hundreds or thousands of individual companies, you just have to invest in an index fund and you’ll track that market. However, even die-hard index fund fans tend to own more than one. You can buy a domestic stock market index fund, an international stock index fund, a bond index fund or an international bond index fund, and allocate your resources according to your risk tolerance.

In addition to their low fees and diversification, index funds tend to generate less taxable income than actively managed funds do. That’s because, since they’re passively following the market, index funds don’t buy and sell as frequently. Fewer sales means less taxable income for the investor. And who doesn’t like the sound of lower taxes?

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No-Load Index Funds

When you look up investment funds, you’ll often see the label “no-load.” No-load means that the fund doesn’t charge commission for each sale. This saves you money, and lets your investments grow more over time. If you’re searching for index funds to invest in, it’s a good idea to look for ones that offer the best deals on commission and fees.

Index Funds and the Efficient Market Hypothesis

What Is an Index Fund?

Proponents of index funds cite the Efficient Market Hypothesis (EMH) as the reason index funds are an investor’s best bet. The Efficient Market Hypothesis states that all the necessary information about stocks is already factored into their price. It’s therefore impossible, the hypothesis holds, to “beat the market” by finding deals or “undervalued” stocks. An index fund assumes that there are no secrets or tips to be found that will let you outperform the market, so why not just… index the market? The first index fund was greeted with skepticism, but now index funds are both popular and respected.

Related Article: What Is a Stock Split?

Bottom Line

Some people make investing their hobby, and derive serious enjoyment from researching and trading stocks. But hey, that’s not for everyone. Others are happy to pay financial advisers for the convenience of not having to think about their investing. And if they can afford it, more power to them. But if you want a low-maintenance, low-cost way to invest your money, for retirement, for a home purchase or for any other financial goal, it can be a good idea to look into index funds. You’ll have the satisfaction of knowing that more of your money is growing and less is going to pay fees. It’s not a flashy approach to investing, but it can be a solid one.

Photo credit: flickr, ©iStock.com/triloks, ©iStock.com/cnythzi

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Amelia Josephson Amelia Josephson is a staff writer covering financial literacy topics at SmartAsset. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.

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