In 1975, John Bogle presented a radical idea to the board of directors of the newly formed Vanguard Group. Bogle wanted to create an extremely low-cost mutual fund that would not attempt to beat the returns of the stock market, as measured by the Standard & Poor's 500 index. Instead, it would attempt to mirror the index as closely as it could, by buying each of the index's 500 stocks in amounts equal to the weightings within the index itself. Bogle's brainchild became known as the index fund.
An index fund is a mutual fund that defines a group of stocks -- an index -- and then buys and holds them all, no matter how they perform. Index funds don't have a professional manager at the wheel, choosing which stocks to buy or sell; instead, they simply seek to automatically replicate the returns of their specific indexes.
The major indexes on which many index funds are based include:
The Dow Jones Industrial Average (DJIA)
After more than a century in business, the DJIA is the oldest continuing U.S. market index. It is comprised of 30 blue chip stocks united only by their absolute hugeness. The DJIA is the world's best-known market indicator, partly because it's old enough that many generations of investors have become accustomed to quoting it, and partly because the U.S. stock market is the world's most valuable.
The Dow includes powerhouse large-cap companies that represent U.S. industry. Its focus on mega-cap companies gives the DJIA significant stability. Each member company is recognizable to significant portions of the investing public. But because it is restricted to U.S.-based companies -- and just 30 companies, at that -- the DJIA is not very diverse, nor truly representative of the market's performance as a whole.
The Nasdaq 100
The Nasdaq 100, not surprisingly, tracks the 100 largest stocks listed by the Nasdaq exchange, a computer network that allows brokers to trade among themselves. The index includes Dow Jones Industrial Average giants Microsoft and Intel.
Though it doesn't specifically favor certain types of companies over others, the Nasdaq 100 tends to house big-name technology stocks that have risen from obscurity to dominate their markets. But this tech-heavy weighting, and the unpredictable, rapidly changing nature of the tech sector, makes the Nasdaq 100 more volatile than broader-based indexes.
The Russell 2000
The Russell 2000 measures the performance of U.S. small company stocks ("small caps," in Street parlance). These aren't the smallest of the small -- just the 2,000 smallest companies in the Russell 3000 index, a broad-based index that includes all but the tiniest micro-cap stocks.
The Russell 2000 is quite diversified, and it's the most quoted index focused on smaller companies. However, it's quite volatile both in composition and in valuation. Small-cap companies may have plenty of promise, but they're also a lot riskier than their larger peers, and they don't tend to lead their respective industries. (At least, not yet.)
The S&P 500
The Standard & Poor's 500 Index is usually considered the benchmark for U.S. equity performance. It represents 500 of the most widely held U.S.-based common stocks, chosen by the S&P Index Committee for their market size, liquidity, and sector representation.
The listed companies are highly diverse, spanning every relevant portion of the U.S. economy. But the S&P 500 is comprised primarily of U.S.-based companies, so it doesn't reflect the global market. In addition, the S&P 500 has significant liquidity requirements for its components, so some large, thinly traded companies are ineligible for inclusion. Because the index gives more weight to larger companies, it also tends to reflect the price movements of a fairly small number of its member stocks.
The Wilshire 5000
Started in 1974, the Wilshire 5000 is often referred to as the Total Stock Market Index, because it seeks to measure the performance of all U.S. equity securities that provide readily available price data. This makes the Wilshire 5000 the most diverse of any U.S.-based index.
However, its 500 largest companies comprise the vast majority of the index's value, so total performance is weighted toward the top few companies, relatively speaking. The Wilshire 5000 does not contain any foreign companies, and thus measures economic performance in the United States only.
Nowadays, you can find an index that covers nearly anything, from stocks in dozens of foreign countries, to a particular industry or sector of the economy. But which investment is best for you? We'll tackle that question next, as we debate index funds vs. actively managed funds.