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An index fund is a mutual fund or ETF that is designed to track a specific index of stocks, bonds, or another type of investment. For example, an S&P 500 index fund would invest in all 500 components of that market index in order to replicate its performance.

Index funds: The basics

An index fund is a mutual fund or ETF whose portfolio is designed to replicate a certain market index. For example, the popular Dow Jones Industrial Average is an index that consists of 30 large U.S. stocks, weighted by share price. So an index fund that tracks the DJIA would be expected to own all 30 stocks in approximately the same proportions that they make up in the index.

The three largest stocks in the DJIA are 3M Company, IBM, and Goldman Sachs, which make up 6.58%, 5.92%, and 5.70%, respectively, of the index. Looking at an index fund that tracks the Dow 30, the SPDR Dow Jones Industrial Average ETF (NYSEMKT: DIA), we can see that these stocks make up 6.59%, 5.89%, and 5.70%, respectively, of the fund's portfolio. Not exactly the same, but pretty close.

Types of stock index funds

Broad market index funds: These invest in an index designed to track the performance of the entire market, or a subset of the market such as large-cap stocks. The Dow Jones Industrial Average, S&P 500, and Russell 2000 indices, are examples.

Global/International index funds:These are designed to provide exposure to stocks all over the world. Global indices include stocks from all over the world, while international indices exclude U.S.-based companies.

Sector-specific index funds: These are designed to track a sector's performance. For example, the Financial Select Sector SPDR ETF (NYSEMKT: XLF) is designed to mirror the performance of the banking, insurance, and real-estate industries.

Why invest in index funds?

Index funds have become quite popular, and for good reason. First, because index funds don't require much effort from managers, they typically have lower fees than actively managed funds. It's not uncommon to find index funds with expense ratios in the 0.05%-0.07% range, while actively managed funds are generally in the 1%-2% ballpark.

Additionally, index funds allow investors to harness the long-term potential of the stock market without the guesswork and research involved with choosing individual stocks. In fact, there are many economists who believe in the efficient market hypothesis -- which says that it's not possible to beat the market consistently, so the best way to invest is to simply buy all stocks. An index fund allows investors to do that.

Leveraged index funds: A different kind of fund

There is a type of fund known as a "leveraged ETF," which is worth mentioning in the context of index funds. These funds often track an index, but aren't the same type of investment as an index fund.

Specifically, leveraged ETFs are designed to produce a multiple of an index's return, or the inverse of it -- but on a daily basis, not over the long term. In other words, if the S&P 500 rises by 3% tomorrow, the ProShares Ultra S&P 500 Fund, which uses 2x leverage, will rise by approximately 6%.

However, if the S&P 500 rises by 10% for the month, the leveraged fund won't necessarily rise by 20%. In fact, it's entirely possible for a leveraged ETF to drop, even though the underlying index produced a positive return over the same time period.

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