Definition: What is an Index Fund?
An index fund is a collectively capitalized, investment fund, which attempts to mirror a certain market index.
For example, an index fund may hold a similar investment portfolio, in terms of ratio, to the Standard & Poor’s 500 Index. Index funds are typically sold as mutual funds; however, many exchange-traded funds are also constructed based on a specific index.
Advantages of Index Funds
Many financial experts believe that index funds are less risky than actively managed mutual funds, since they are constructed to mirror the market, rather than outperform it.
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In addition, since market indexes are highly diversified in nature, investing in index funds is far less risky than purchasing one type of security or shares in a few firms.
Index funds typically also hold extensive securities, which pay dividends to investors, so profits are not restricted to capital gains.
Another advantage of index funds is that they typically do not have high administrative or managerial costs, since they require less oversight to manage.
Disadvantages
Like many other mutual funds or investments, index funds are still vulnerable to market volatility, and systemic risk.
For example, during a severe economic recession, an index fund’s value may drop considerably.
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