Imagine a stock index – let’s call it the ABC index – that contains 2 stocks:- American Express and Kraft. Let’s say that the ABC index is made up of 60% American Express and 40% Kraft. If an index fund is based on the ABC index then it too will also invest in American Express and Kraft – 60% of the index fund will be American Express and 40% will be Kraft.
These percentages will change as the values of American Express and Kraft change. If the price of the American Express stock increases and the price of Kraft decreases then the index will change so that maybe 65% will be American Express and only 35% will be Kraft.
An index fund can mimic any type of index. Different indexes can follow a broad stock market index such as the S&P 500 or Dow Jones or something a lot more specific such as junior mining stocks. Indexes can also cover non-stock investments such as bonds or commodities (such as oil).
The two main theories behind index funds (and passive investing) are as follows:
1) Most managed mutual funds can’t beat their index over any length of time and it is impossible to predict which ones will beat the index in any given time period.
2) The significantly lower costs of index funds will ensure that on average, index fund investors will have better returns than their managed mutual funds counterparts.
Photo by evolutionary journeyman.