Index funds basics and how do index funds work
|June 9, 2011||Posted by John Border under Fund Management, Index Funds, Investment Idea|
Well before we take a plunge into the index funds the thing that you need to know is what is an index and how does it reflect the overall state of the stock market.
What is an index?
The index is a list of stocks which in general will mirror the overall state pof the market and that will help you to decided whether to invest or not. Mr. Charles Dow first start the Dow Jones Industrial Average index called DJIA and it has some 30 stocks in the index. These 30 stocks represent the overall market.
You may ask a question as to how 30 stocks can represent the entire stock market. As the time has gone by these 30 stocks have come to represent the biggest and the most influential stocks representing all sorts of industries and that helps as they are kind bellwether stocks for their industry.
There are other indices which are now in vogue and which may be give a better picture of the market and these are the S&P 500 and the NASDAQ 100. These indices are again for various stock exchanges and again by different companies in some cases say S&P.
Now there are more indexes like the Wilshire 5000 total market index which takes into account about 6500 stocks and may represent the stock market in a better way.
What are index funds?
Index funds are mutual funds which do not track the stocks individually and rather just track the underlying index. What that means that these mutual funds will only make sure that stocks that they hold just mirror the exact weightage of stocks in the index and the returns usually will mirror the index funds.
Passive vs. active and the associated returns
Now since these funds are not actively managed the returns will mirror the returns from the index movements and they will usually not outperform the index and on the other side it will go down as much as the index. Now the actively managed funds may just outperform the index depending on the find managed but they can go horribly wrong and unperformed the index by a long margin.
Since the index finds do not require active fund management , the expense fee of the index funds is generally less and that helps as then you can very well make better returns than from actively managed funds over a longer period of times.
As far as holding of the index funds is concerned they are more likely to give you returns over a longer period of time and hence the period of holding is very important.