What are Index Funds?

Published by Thomas Herold in Investments, Retirement, Trading

'Index Funds' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Index funds are typically exchange traded funds or mutual funds. Their goal is to reproduce the actual movements of an underlying index for a particular financial market. They do this no matter what is happening in the overall stock markets.

There are several means of tracking such an index. One way of doing this is by purchasing and holding all of the index securities to the same proportion as they are represented in the index. Another way of accomplishing this is by doing a statistical sample of the market and then acquiring securities that are representative of it. A great number of the index funds are based on a computer model that accepts little to no input from people in its decision making of the securities bought and sold. This qualifies as a type of passive management when the index fund is run this way.

These index funds do not have active management. This allows them to benefit from possessing lesser fees and taxes in their accounts that are taxable. The low fees that are charged do come off of the investment returns that are otherwise mostly matching those of the index. Besides this, exactly matching an index is not possible since the sampling and mirroring models of this index will never be one hundred percent right. Such variances between an index performance and that of the fund are referred to as the tracking error, or more conversationally as a jitter.

A wide variety of index funds exist for you to choose from these days. They are offered by a number of different investment managers as well. Among the more typically seen indices are the FTSE 100, the S&P 500, and the Nikkei 225. Other indexes have been created that are so called research indexes for creating asset pricing models. Kenneth French and Eugene Fama created one known as the Three Factor Model. This Fama-French three factor model is actually utilized by Dimensional Fund Advisers to come up with their various index funds. Other, newer indexes have been created that are known as fundamentally based indexes. These find their basis in factors like earnings, dividends, sales, and book values of companies.

The underlying concept for developing index funds comes from the EMH, or efficient market hypothesis. This hypothesis claims that because stock analysts and fund managers are always searching for stocks that will do better than the whole market, this efficient competition among them translates to current information on a company’s affairs being swiftly factored into the price of the stock. Because of this, it is generally accepted that knowing which stocks will do better than the over all market in advance is exceedingly hard. Developing a market index then makes sense as the inefficiencies and risks inherent in picking out individual stocks can be simply eliminated through purchasing the index fund itself.

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The term 'Index Funds' is included in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.