Index Funds

Updated on February 13, 2007.

IF YOU'RE JUST GETTING started in building a mutual fund portfolio, buying an index fund can be one of the easiest, most effective ways to go. If the goal is long-term growth and simplicity, these no-fuss funds are a great solution.

So how do they operate? Technically, index funds do have managers, but they don't have a heck of a lot to do. They simply buy all the stocks or bonds in a chosen index with the goal of matching that group's performance. And what's an index? It's a grouping of stocks chosen to represent a certain market segment. The S&P 500 index (the index most widely tracked by index funds), for instance, consists of large-cap stocks. The Nasdaq Composite index is heavy on technology companies. And the Russell 2000 is a benchmark for small-cap companies. (See our Stocks course for more on how stocks behave.)

Index funds have two advantages that help them deliver solid returns: tax efficiency and low expenses. Low turnover limits tax liability (see Cost Control). And since the manager doesn't have to look actively for stocks, these funds are relatively cheap to operate. The Vanguard 500 Index fund, for example, has an incredibly low annual fee of 0.18% of your investment. The average large-cap fund charges more than six times that much.

Keep in mind, though, that these advantages do not make index funds immune from losses. An index fund will be just about as volatile as the index it tracks. In 2006, the S&P 500 delivered an impressive gain of 15.8%. But back in 2001, during the bear market, this index lost 22.2%.

That said, over time, the return of this index has been decidedly positive: Since 1926, it's delivered 10.5% average annual returns. So while you shouldn't necessarily expect a smooth ride, we think index funds can still make up the backbone of a solid, long-term portfolio. Yes, a terrific fund manager should be able to beat the index. But most managers don't. In fact, over the past five years, more than 50% of all mutual funds have underperformed the S&P 500 on a cumulative basis.

Bottom line? While index funds can be bumpy over the short term, we believe they're one of the best options around for long-term investors.