Index funds track a specific market index, such as stocks, bonds, commodities, or social responsibility, and aim to match its performance. Some index fund managers use active management techniques, but this can increase fees and negate the main advantage of index funds.
An index fund is a type of security whose value follows a measure, or index, of a specific segment of a financial market. The most common are stock index funds, which track a particular stock market index, such as the S&P 500. Although stock index funds are the best-known type, index funds can track other types of indicators. There are also bond index funds, commodity index funds, and index funds that try to track various segments of an industry, such as real estate or the economic health of a country, such as the All Ordinaries Index, which tries to track The State of the Australian Economy. Some index funds even track indices tied to social responsibility or environmental concerns, such as the NYSE Arca Environmental Services Index.
A stock market index fund may track a global or world index, which represents a group of companies from multiple countries. The index fund may alternatively track a national index of a particular nation, reflecting the state of the country’s economy. Two examples of a national index are the Japanese Nikkei 225 and the British FTSE 100. Although the terms global index or world index might suggest that the index fund tracks the global economy, that is not the case. The global or world index fund simply indicates that the companies in the fund represent many countries. An example of a global index fund is Morgan Stanley Capital International (MSCI), which holds shares of 1,500 companies with a global presence in 23 developed market countries.
Bond index funds track specific corporate or municipal bond indices, such as the Lehman Brothers Aggregate Bond Index, which includes government, mortgage-backed, and corporate fixed-income securities. Other bond index funds are a sample of the short-, medium-, and long-term bond markets. Bond funds are generally a guarantee that provides cash to a government or company in exchange for a guarantee that has a specified maturity date. At maturity, the bondholder can collect the bond for face value plus interest.
Commodity index funds track specific commodity markets and commodity futures. These index funds provide opportunities for less experienced investors to invest in a market that has a reputation for being complex, risky, and best left to the professionals. One advantage of investing in commodity index funds is that, historically, commodities fluctuate independently of stocks and stocks because commodities fluctuate in response to supply and demand. This provides an investor with a more diverse portfolio.
Although, by definition, an index fund is a passively managed collateral that tracks a specific market index, some index fund managers are expanding the definition of index funds by adopting different indexing techniques, many of which require some degree of active management. Some index fund managers are taking a more active and hands-on approach by using strategies and timing rules to more closely track an index. However, this approach can negate one of the main advantages of an index fund: lower fees. Additionally, index funds account for more than 80 percent of actively managed mutual funds. The goal of index funds is not to beat the index, as is the case with traditional stock and stock funds, but to match it.
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