Index Fund Defined

• An index fund buys and hold the same securities -- stocks or bonds -- in the same proportion as a designated index. For example, the S&P 500 stock index owns the 500 largest U.S. stocks by market value based on market capitalization. An S&P 500 index fund will own the same 500 stocks to match the index. An index fund will provide a return to investors which matches the return of the specified index. Index funds are passively managed, only buying and selling securities when changes are made to the index.
  
  

Index Fund Costs

• According to the Investment Company Institute 2010 Factbook, the average stock mutual fund expenses are .99 percent of fund assets per year. Since index funds are passively managed and do little trading, they can be managed at a lower cost. Stock or bond index funds typically have expense ratios of .25 percent or lower. Some very low cost funds have expenses below .10 percent. The low expense ratios of index funds when compared to actively managed funds put the "low cost" into low cost index funds.
  
  

Two Types of Index Funds

• Low cost index funds can be either mutual funds or exchange traded funds, ETFs. Index mutual funds are available from several major fund families and track the major stock and bond indexes. Index funds are a small portion of the almost 7,000 stock and bond mutual funds. Exchange traded funds are all index funds in one form or another. To form a new ETF, the fund company must first have an index for the fund to track.
  
  

Index vs. Actively Managed

• Mutual fund investors have a choice of actively managed funds or passive index funds. The argument for index funds is that the majority of actively managed mutual funds fail to out perform the stock indexes tracked by the index funds. The low expenses of index funds give those funds an additional performance benefit over more expensive actively managed funds. For actively managed funds, there are funds which do beat the indexes and active fund management allows a fund to react to changes in market conditions.