An index fund is a kind of investment fund that tends to replicate the performance of a certain index of stocks. It is actually a kind of exchange-traded fund or a mutual fund. The major function of the index fund is to offer broad exposure to the financial market with low portfolio turnover and low operating expenses.
The fund can follow a particular financial market index, usually the Standard and Poor’s 500 index (S&P 500), by matching and tracking its components. The index fund can also mimic the performance of other investment type like bonds or some small-cap technology companies.
How does an index fund work?
Most index funds are managed in a passive way. The fund manager will first identify an already well-known index. The index is mainly maintained via a respected third party. Then, the fund manager will build a fund with a portfolio containing holdings that replicate the securities of the famous index. The point is that the index fund can match the performance by mimicking the profile of the index. The fund either owns every asset in the index or achieve the same result by holding similar securities.
Almost every financial market existed has an index and an index fund. While most index funds track the S&P 500, there are other widely used indexes. Major indexes include Nasdaq Composite, Dow Jones Industrial Average (DJIA), Russell 2000 and so on.
Generally speaking, the portfolios of index funds will substantially change only when the benchmark indexes change. If a fund is mimicking a weighted index, the manager will periodically re-balance the percentage of different securities so that the fund can reflect the weight of its presence in the benchmark.