An index fund is a type of mutual fund or exchange-traded fund (ETF) that seeks to track the returns of a market index. The most commonly known index fund in the United States is the S&P 500 Index Fund, which is based on the rules established by S&P Dow Jones Indices for their S&P 500 Index. The funds rules of construction clearly identify the type of companies suitable for the fund, and 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.
Index funds follow a passive investment strategy, seeking to match the risk and return of the market based on the theory that in the long term, the market will outperform any single investment. Instead of a fund portfolio manager actively stock picking and market timing, the fund manager builds a portfolio whose holdings mirror the securities of a particular index. Index funds may take different approaches to track a market index: some invest in all of the securities included in a market index, while others invest in only a sample of the securities included in a market index.
Investors like index funds because they offer immediate diversification, and with one purchase, investors can own a wide swath of companies. Index funds typically carry less risk than individual stocks and are a great investment for building wealth over the long-term, which is why they are popular with retirement investors.
