Index mutual funds are stock market investing tools that seek to match the investment returns of a certain group of stocks, called an index. Index mutual funds own only the stocks that make up the corresponding index, and they carry lower annual expenses than other types of mutual funds. The fund owns the stocks in proportion to the weight of each stock to the index. Different indexes usually track a particular business segment of the stock market, such as financial institutions or European-based companies. Some indexes track a large segment of the market, such as the 500 largest companies, or even the market as a whole.
A mutual fund is a collection of stocks that the fund owns. An investment house sets up the mutual fund and sells shares in the fund to individual investors. Mutual funds simplify the chore of investing in a diversified collection of stocks for individual investors. Rather than trying to buy dozens of stocks to diversify an investment portfolio, an individual investor can invest in a mutual fund that is already diversified.
The fund management style differentiates index mutual funds from managed mutual funds. A managed mutual fund relies on a fund manager or stock picker to decide which stocks to own and in what ratio to own them. The fund follows its original target sector, but the fund manager has a lot of leeway in selecting the stocks and the ratio of the stocks. The fund manager might try to time market corrections, moving the fund's assets into and out of cash.
An index fund, meanwhile, is not actively managed. Instead, because the fund only owns stocks that match the index it attempts to track, the index mutual fund manager doesn’t have to make choices about which stocks to own and in what configuration. An index mutual fund has a far lower management cost than a managed mutual fund because it doesn’t pay a fund manager to actively manage the fund, and the index fund passes those lower costs to those investors who own the fund. Managed mutual funds also buy and sell stocks far more often than index mutual funds, meaning the actively managed funds incur more transaction costs than index mutual funds. For these reasons, an index mutual fund sometimes is called “passive” investing.
In his book, Common Sense on Mutual Funds, John Bogle, the founder of the Vanguard Group, presents an in-depth analysis on the idea of index mutual funds. Investors consider Bogle the “father” of index funds, and Vanguard has offered index mutual funds to its investors since its 1974 founding. These days, many different investment companies offer at least a few index mutual funds. Funds that track the S&P 500 index, which is an index that represents the 500 largest stocks in the American stock market, are common index mutual funds. Indexes sometimes remove and add certain stocks, meaning the index mutual fund must follow suit, but such changes are rare.