When you invest in mutual funds or exchange-traded funds -- ETFs -- there is no way to predict the future return that a fund will pay. But you do know exactly how an index fund will choose the stocks or bonds it invests in. You pick an index fund based on which market index meets the return potential you want for your portfolio.
Index Fund Function
The investment holdings of an index fund match the component securities of a specified index. For instance, an index fund tracking the Standard & Poor's 500 index will own the same 500 stocks that make up S&P 500, and in the same proportion. Because an index fund does not require investment analysts to pick securities, most index funds have operating expenses much lower than those of actively managed funds.
Types of Indexes
The index tracked by a specific fund could be a stock or bond index. It might provide broad market coverage or focus on a narrow sector. Broad market index funds track total stock market or total bond market indexes. Focused index funds own securities to match a narrowly focused index, such as gold mining stocks, telecommunications companies or high yield bonds. The reason behind all of the different indexes and matching funds is to offer exposure to different potential investment returns.
Fund vs. Index Results
An index fund will match the results of the designated index, with two differences. The index itself does not have expenses, but a mutual fund or ETF does have operating expenses. The fund will underperform the index by the reported annual expense ratio, which can range from less than 0.10 percent per year up to about 0.50 percent, depending on the fund. The fund can also earn dividends on its securities holdings. Dividends are not usually included in the performance results of an index, so this difference could result in fund returns greater than the index returns. The total return of an index fund will be the index value change, plus earned dividends, minus expenses.
Popular Index Returns
The returns on index funds vary significantly depending on the index and market. As an example, the average return of the S&P 500 stock index for the 10 years ending Dec. 31, 2012 was 7.10 percent. The S&P 500 index mutual funds from Fidelity and Vanguard produced returns of 7.03 and 6.99 percent annually, respectively. Looking at bond index funds, the Vanguard Total Bond Market Index Fund produced a 10-year average annual return of 5.07 percent, compared to 5.20 percent for the Barclay's bond market index that the fund tracks.
Match the Market Returns
Index funds can match the return of a specific stock index with low operating costs. The annual expenses of actively managed mutual funds average several times greater than the expenses of index funds. Over the longer term -- three to five years and longer -- only about one-third of actively managed mutual funds outperform a comparable index. Investors who want to go with the odds invest in the stock and bond markets using index funds.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.