Index fund

An index fund (also index tracker) is a mutual fund or exchange-traded fund (ETF) designed to follow certain preset rules so that it can replicate the performance of a specified basket ("benchmark") of underlying securities.

The main advantage of index funds for investors is they do not require much time to manage—the investors will not need to spend time analyzing various stocks or stock portfolios. Most investors also find it difficult to beat the performance of the S&P 500 index. Indeed, passively managed funds, such as index funds, consistently outperform actively managed funds. Thus investors, academicians, and authors such as Warren Buffett, John C. Bogle, Jack Brennan, Paul Samuelson, Burton Malkiel, David Swensen, Benjamin Graham, Gene Fama, William J. Bernstein, and Andrew Tobias have long been strong proponents of index funds.

The above mentioned rules may include tracking prominent indices like the S&P 500 or the Dow Jones Industrial Average or implementation rules, such as tax-management, tracking error minimization, large block trading or patient/flexible trading strategies that allow for greater tracking error but lower market impact costs. Index funds may also have rules that screen for social and sustainable criteria.

In general, tracking can be achieved by trying to hold all of the securities in the index in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and are thus subject to a form of passive management. See § Indexing methods below.

An index fund's rules of construction clearly identify the type of companies suitable for the fund. The most commonly known index fund in the United States, the S&P 500 Index Fund, is based on the rules established by S&P Dow Jones Indices for their S&P 500 Index.

Equity index funds would include groups of stocks with similar characteristics such as the size, value, profitability and/or geographic location of the companies. A group of stocks may include companies from the United States, non-US developed, emerging markets or frontier market countries.

Additional index funds within these geographic markets may include indexes of companies that include rules based on company characteristics or factors, such as companies that are small, mid-sized, large, small value, large value, small growth, large growth, the level of gross profitability or investment capital, real estate, or indexes based on commodities and fixed-income.

Companies are purchased and held within the index fund when they meet the specific index rules or parameters and are sold when they move outside of those rules or parameters. While index providers often emphasize that they are for-profit organizations, index providers have the ability to act as "reluctant regulators" when determining which companies are suitable for an index. Some index providers announce changes of the companies in their index before the change date whilst other index providers do not make such announcements.