Index funds are designed to match the investment results of a specific market index. An index fund can include either stocks or bonds in its portfolio, and these mutual funds vary in the tactics that they employ to achieve returns in line with their chosen index. Index funds contrast with non-index funds, which seek to improve on market returns rather than align with them.
Advantage: Low Risk and Steady Growth
A central advantage to index funds is that they are relatively low-risk options for investing in stocks and bonds, designed for steady, long-term growth. They are inherently diversified, representing many different sectors within an index, which protects against deep losses. Also, index funds often perform better than the majority of non-index funds that strive to beat the market. For instance, U.S. News & World Report noted in 2011 that index funds tied to the Standard & Poor's 500 index generated better returns over the previous three years than almost two-thirds of large-cap actively managed mutual funds.
Advantage: Low Fees
Index funds offer lower fees for investors than non-index funds. This means that even when a non-index fund outperforms index funds, it must perform better by a certain margin to generate returns that overcome the fees that it charges. One reason for the higher fees is that funds that are actively managed tend to have many more transactions than index funds, which are more passively traded because they stick to an index. And funds' transaction fees can accumulate.
Disadvantage: Lack of Flexibility
Because index fund managers must follow policies and strategies that require them to attempt to perform in lockstep with an index, they enjoy less flexibility than managed funds. Investment decisions on index funds must be made within the constraints of matching index returns. For instance, if the returns in an index are declining strongly, index fund managers have few options in an attempt to limit those losses. In contrast, managers of an actively managed fund have more flexibility to act to find better-performing options in good times or in bad.
Disadvantage: No Big Gains
An index fund does not carry the potential to outpace the market the way that managed funds can. This means that if you invest in an index fund you are surrendering the possibility of a massive gain. The top-performing non-index funds in a given year perform better than the top-performing index funds, and the very best non-index funds can perform far better than an index fund in a year. However, the top-performing non-index funds may vary from year to year, so that under-performing years can cancel out the over-performing ones, while index funds' performance remains more steady.
- Securities and Exchange Commission: Index Funds
- Making the Most of Your Money; Jane Bryant Quinn; 1997
Tom Gresham is a freelance writer and public relations specialist who has been writing professionally since 1999. His articles have appeared in "The Washington Post," "Virginia Magazine," "Vermont Magazine," "Adirondack Life" and the "Southern Arts Journal," among other publications. He graduated from the University of Virginia.