The 80s were all about mutual funds. The last decade it was day trading and cheap online trading. This decade it's all about indexing. Index Funds can help you implement an indexing strategy, but they aren't the only option. This section will walk you through all the details you need to know.
Index Fund Primer
Index Funds are often confused with Exchange Traded Funds which are also known as ETF or ETFs. Index Funds are mutual funds. There is no difference in the way they are structured from any other mutual fund you have seen. What makes them different is the investments they make, not how they are setup.
What is An Index
There is no "The Market." Although people constantly say things about "the market" being up or down, there is no "the market." For starters, there are several public exchanges in the U.S. alone. Some of them are stock markets, but there are also options markets, commodity markets, and and so on. Of course, there are also international markets in most major (and some not so major) countries. Assuming we limit it to just major U.S. Stock Markets we still have three to choose from. Assuming we limit it even further to just the New York Stock Exchange known as the NYSE we still have thousands of stocks. On any given day, some of those stocks will be up and some will be down. So how can we talk about "the market"?
One way to simplify the complexity of the world markets in order to be able to better talk about and analyze them is to break them down into smaller pieces. An index is one way to do this.
An index is nothing more than a predefined collection of investments. The Dow Jones Industrial Average is the most widely known market index. It is commonly known simply as the "Dow Jones" although the Dow Jones company has many indexes. When people say "The market was up 119 points yesterday," what they mean is that the Dow Jones Industrial Average Index was up 119 points yesterday. That doesn't mean that all stocks were up yesterday, or even that most stocks were up yesterday. Because of the makeup of the Dow Jones Industrial Average, it is possible for it to be up when most stocks are down and vice versa. So what exactly are we talking about?
The Down Jones Industrial Average is a theoretical portfolio consisting of 30 of America's largest industrial publicly traded corporations. It is not THE 30 largest it is 30 OF the largest. The Dow Jones is what is reffered to as a managed index. A managed index is composed of investments that are chosen by human beings. The Dow Jones Industrial Average is a way to watch and analyze the status of large U.S. blue chip companies. The stocks in the index are chosen by the people at the Dow Jones company according to their own internal methodology. They decide when to add or remove companies from the index. No one else has any say in the make-up of the index. So if a company on the index ceases to exist though aquisition or bankruptcy the Dow Jones people get to determine which company takes the old company's place. Before an announcement is made, there can be only speculation as to who the replacement will be.
Passive indexes are conversely created via mathmatical formula or static methodology. For example, there could be an index of the 30 largest stocks in the U.S. as measured by their overall market capitalization. In this index, there is no one company or person who decides what companies are in the index. Instead, the index reacts according to a pre-determined mathematical formula. So if a company that was in the index ceases to exist, it would be readily apparent to everyone who the replacement would be. In fact, such an index (if it existed) could be updated the very next day. Obviously daily changes in an index are undesirable so in this case such an index would likely be updated on a limited basis (again in a predetermined mathematical fashion such as quarterly or even annually.)
Although anyone can theoretically create and index only certain players have the clout to create indexes that are followed by the masses. These players can (and do) create or eliminate indexes at any time. Whether anyone chooses to use the indexes is another matter.
Index Investing - Using INdexes To Invest
Indexes are nothing new. The Dow Jones Industrial Average has been around for over a century. However, it has been only recently that indexes have become widely used for direct investment purposes by the public at large.
Because an index is a predetermined portfolio it has several advantages over more traditional mutual funds. The two most important features are transparency, cost and taxes.
Mutual funds hate to disclose what holdings they have inside their mutual funds. One reason is that they don't want people copying their portfolio and getting a "free ride" on their research and strategy. Another reason is that if people can watch the portfolio then can see how good the manager is. When does he screw up, what trends did she miss and so on. So, mutual funds only release their holdings quarterly or less. Index funds on the other hand tell you exactly what is in them. Whether passive or active all indexes are public. So, you always know what is in an index fund.
Want to invest in big U.S. companies, but don't like the fact that GM is in the Dow Jones? Find another index. It's that simple.
The second advantage of index funds is cost. A regular mutual fund requires a fund manager, and analysts, and traders, and so on. Each of those people need computers and network connections and subscriptions to research services, not to mention if you are flying people around to meet with executives or do other research. Because and index fund is pre-packaged, you don't need any analysts or managers, so your expenses are much lower. So index funds tend to be much cheaper to invest in.
Another advantage of index fund investing is tax-efficiency. Because indexes don't change very often, an index fund doesn't have to sell very often either. If there are no sells, there are no capital gains, so and index fund can be more tax efficient. (Some regular mutual funds have tax strategies as well, so this won't apply to all funds.)
Buying INdex Funds
Buying index funds is just like buying regular mutual funds. Find a mutual fund company that offers the fund you want and buy shares. The main players in the index fund world are Vanguard and Fidelity. There are others, but I'd start with those two until you are familar with their offerings.
There are litterally thousands of indexes out there these days. Start with these major players.
Standard and Poors -- Responsible for the S&P 500 and others
Dow Jones -- Responsible for "The Dow" Dow Jones Industrial Average
Wilshire -- Responsible for the Wilshire 5000 which is widely known as a "total market" index
Morningstar -- Morningstar runs its own indexes now and more funds are using them.