Let’s start with the most fundamental question first: what is a mutual fund? A mutual fund is a type of investment that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, and other assets. One of the main advantages of a mutual fund is that it gives small investors access to a diversified portfolio of securities that would be very difficult to duplicate with a small amount of capital.
An index fund is a type of mutual fund that is constructed to match the performance of a market index. A market index that you might recognize is the S&P 500, which is based on the 500 leading publicly-traded companies in the U.S. stock market. There are many other stock and bond indices that index funds have been designed and created to track, some of which are addressed below.
Index-based ETF’s (“ETF” stands for exchange traded funds) are simply index fund-like investments that can be actively traded on the stock market like any other stock or bond security.
Index funds are primarily designed to be used in a so-called “passive” form of portfolio management, where the index funds are purchased and held for a long time period without active trading. This is also referred to as a “buy and hold” strategy.
The primary advantages of a passive, buy and hold investment strategy utilizing index funds are:
- Low costs – Index funds generally have very low fees, also called the fund’s “expense ratio,” and do not incur as many of the costs associated with investing as does active portfolio management, such as sales commissions on buying and selling securities.
- Tax efficiency – Also as a result of low turnover (very little buying and selling), this investing strategy minimizes taxes.
- Diversification – Broad-based index funds mimic the performance of indices that comprise hundreds or thousands of different securities, so they generally are extremely well diversified.
- Simplicity – This strategy can be implemented with the purchase of a minimal number of mutual funds (as few as one) and can be maintained by easily “rebalancing” your investments every 1 – 2 years.
A word of caution here on indexing: to implement a true buy and hold strategy, only the most broadly-based index funds should be invested in and they should be held long term (ideally for years or decades). The indices you should invest in are ones such as the S&P 500 (described above), the DJ Wilshire 5000 (total U.S. stock market), the Russell 2000 (small U.S. stocks), the MSCI EAFE (foreign stocks in Europe, Australasia, and the Far East), and broad-based bond indices. There are index funds and ETF’s that are based on very tiny slices of the market, like biotechnology or health care stocks, that offer poor diversification and should be avoided.
Last, I would be remiss if I didn’t plug my favorite mutual fund company for index-based mutual funds: Vanguard. Vanguard originally developed the concept of index-based investing and has remained true to its philosophy for decades. It is extremely well run and has some of the lowest cost index funds in the industry. To be fair, Fidelity Investments and T. Rowe Price also offer excellent index funds.