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Investing in Index Funds

Investing in Index Funds

Following up on Shorting a Stock: What Does It Mean?, this week we’ll discuss investing in index funds, a passive investment strategy that reduces time spent researching stocks, reduce investment fees, provide built-in diversification, and reduce risk by linking your investment to the overall returns of markets over time.


Index funds are mutual funds designed to mimic or track the performance of market indexes like the S&P 500. With index funds, an investor can only meet the market's performance. They cannot beat it.

Every index fund tracks a market index. Some of the common index funds include:

  • Broad market index funds. These funds mostly track securities listed on one of the many indexes. Some of the common indexes that funds follow are the Standard & Poor's 500, the Dow Jones Industrial Average, and the Nasdaq Composite.
  • Equity index funds. Equity index funds track the total return of the broad U.S. equity market, including large-, mid-, and small-capitalization stocks. There are index funds that track all the major stock indexes, such as the Nasdaq Composite or the Russell 2000.
  • Bond index funds. Also called fixed income index funds, these funds track the performance of specific types of bonds. Bond index funds invest in corporate debt, government bonds and municipal bonds of varying maturities and quality. The primary goal of a bond fund is often that of generating monthly income for investors.
  • Balanced index funds. These funds invest across asset classes. For example, a balanced index fund portfolio could be 60% stocks and 40% bonds.
  • Sector index funds. These funds invest specifically in the stocks and securities of a particular industry or sector. For example, the manager of a consumer staples index fund would only buy stocks in the S&P 500 consumer staples category, including companies in the food, beverage, and household goods businesses.
  • Dividend index funds. If your goal is to generate income, dividend index funds focus only on indexes of stocks paying dividends. Investing in dividend index funds could help you to keep pace with inflation.
  • International index funds. To invest outside the United States, you could buy into an international index fund which track indexes in other countries.
  • Environmental, Social and Governance (ESG) index funds. A social index fund looks to promote causes like protecting the environment. The fund would only invest in companies that meet its mission.

Portfolios of index funds only change substantially when their benchmark indexes change. If the fund is following a weighted index, its managers may periodically rebalance the percentage of different securities to reflect the weight of their presence in the benchmark.

A price-weighted index takes into account each asset’s market price. Higher-priced assets have a bigger share in the index than lower-priced assets. The Dow Jones Industrial Average is a price-weighted index, since the price per share of each component stock determines its weighting in the index.

A market-cap-weighted index considers each asset’s market capitalization, or the total amount of money invested in the asset, to determine its share in the index. The S&P 500 is a market-cap weighted index, as each component company’s market capitalization determines its share of the index.

Be sure to compare different index funds to be sure you are tracking the best index for your goals and at the lowest cost. It’s important to understand that there are many funds that track the same indexes but charge different fees.