Course 211: What to Look For in a Fund
Index Funds
In this course
1 Introduction
2 Index Funds
3 Funds of Funds

Index funds are about as simple as it gets. You might remember from "Lesson 209: Why Knowing Your Fund Manager Matters" that index-fund managers aren't picking stocks in the traditional sense. Instead, they are buying the same stocks in the same proportion as they appear in a particular index. In other words, they don't buy a stock because they like a company's prospects or sell because a firm's outlook has become less than rosy. They simply own the index. They are passive investors.

Index funds have plenty of benefits. Most important, they tend to be low in cost. For example, Schwab 500 Index's SWPPX expense ratio is just 0.09% versus 0.84% for the typical large-blend fund. Because the index-fund managers aren't actively managing their funds—instead of making buy and sell decisions, they're simply doing what the index does—management fees tend to be low.

Index funds are also advantageous because they are fairly predictable. First, they tend to return what the index does, minus their expenses. Second, they always own what the index owns, which means they tend to be style specific. For example, if a fund indexes the S&P 500, that means it owns large-blend stocks; it'll own those types of stocks today, tomorrow, and the next day. You know what to expect from an index fund. Funds that aren't indexed, also called actively managed funds, might not own the same types of stocks day in and day out. It all depends on the manager's style. He or she may like large companies one day and then see value in smaller firms the next.

Finally, index-fund investors don't have to worry about manager turnover: If the manager leaves, the next manager is likely to do just as well, as long as the mutual fund shop's resources haven't changed. Nor is asset size an issue. Index funds can handle plenty of assets, because they generally don't use fast-trading strategies.

If you only plan to own one index fund for awhile, make sure it favors large companies. Some funds, including Vanguard Total Stock Market Index VTSMX, hold stocks of all sizes, though larger companies are most heavily represented. Such funds would be excellent choices for one-fund owners.

Next: Funds of Funds >>

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