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What Are Index Funds?

By Motley Fool Staff – Oct 11, 2016 at 7:31PM

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Thousands of new index funds and ETFs have launched in just the past decade. Here’s how they differ from other types of investment funds.

The index fund may be the biggest invention in Wall Street history. From relative obscurity just a few decades ago, index funds grew to become more than a third of all stock fund assets under management.

What exactly are index funds, anyway? In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss the differences between index funds and more traditional mutual fund investments.

A full transcript follows the video.

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This podcast was recorded on Sept. 14, 2016.

Gaby Lapera: Jordan, I'm going to start with an extremely softball question. What is an index fund?

Jordan Wathen: An index fund is, technically speaking, any kind of fund that invests in an index and isn't actively managed. An actively managed fund hires portfolio managers and analysts to find good stocks and bonds that they think will make great investments, and they generally seek to outperform the market, or outperform a benchmark. Index funds, on the other hand, they just buy the index. If you buy a traditional S&P 500 index fund, like Vanguard's 500 index fund, it buys and sells all the stocks in the S&P 500. That's all it does. If a stock is removed from the S&P 500, then the fund sells it. If a stock is added to the index, then the fund buys it.

Lapera: Just for our listeners, in case you haven't caught on to this, there are these things called indexes, and they work just like an index in a book. They list everything that's in the book. The index lists everything that's in that particular index, stock index, which is why it's called the S&P 500 Index.

Wathen: Right. The S&P 500 Index generally holds 500 of the largest companies in the United States, or that trade on U.S. markets.

Lapera: Right. You were talking earlier about mutual funds trying to beat their benchmark. Typically The benchmark is some kind of index.

Wathen: Right, typically it is an index. It depends. Bonds have bond indexes, bond investors aren't trying to beat stocks. And stock investors would hope that they could outperform bonds, generally, but they're not benchmarked to bonds.

Lapera: Can you name any other more commonly known stock indexes for our listeners?

Wathen: The S&P 500 is a large-cap index. It holds 500 of the largest stocks in the United States. On the other end of the spectrum would be, say, the Russell 2000, which holds small-cap stocks in the United States.

Lapera: Just so our listeners know, cap refers to market capitalization. A large-cap stock would be a company whose market capitalization is above $5 billion. Of course, that figure varies depending on who you ask. But around $5 billion is good enough for our purposes. Small cap is, obviously, a lot smaller. When I say a lot smaller, I mean, say, $200 million. It's a lot, lot smaller.

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