Mutual Funds: Index Funds

Over the long haul, it's pretty tough to beat the market, which historically has churned out average annual returns of about 10%. In the "If you can't beat 'em, join 'em" spirit, index funds were created.

Index mutual funds aim to match the performance of a securities index by purchasing shares of all or nearly all of the stocks in that particular index. The granddaddy of all index funds (and still the biggest index fund), the Vanguard 500 Index, was created in 1976 for investors to track the performance of the S&P 500, a broad index that lists 500 large companies from a cross-section of sectors. Since then, index funds have cropped up that mirror just about every index out there: small-cap indices, sector indices, you name it. Indeed, there are even "enhanced" index funds that try to slightly exceed the performance of a given benchmark, but that isn't always easy to do. (Another growing segment of index funds are exchange-traded funds .)

Because the aim of most index funds is merely to mirror an index's performance, the funds aren't actively managed. This means the management fees are typically far less expensive than most mutual funds. Their relatively low cost is a key factor in their popularity.

Keep in mind that index funds don't try to set the world on fire, they only want to match an index. If the benchmark index goes up about 10% for the year, so does the index fund. If the benchmark declines 10% for the year, so does the index fund.

While the first index fund and other early index funds tried to match indices such as the S&P 500 that represented a fairly broad swath of the market, more recent index fund offerings, such as the Internet index funds, are pretty concentrated, and shouldn't be construed as a diversification strategy.

Like all investment vehicles, indexing has its proponents and its detractors. Whether it works for you depends on what you want out of your portfolio. Want to swing for the fences and take on some risk in a bid to beat the pack? Try an actively managed fund. Want to "join 'em," and be content with matching the index of your choice? Look no further.

Index Pointers

TheStreet.com's Personal Finance section covers the latest changes in the index fund world extensively. In the meantime, index funds cover a wide terrain; these articles provide a road map.

Dear Dagen's Keep Swimming in the Index Pool

Managing an Index Fund Isn't Monkey Business

Dear Dagen's What's the Right Mix of Index and Actively Managed Funds?

There's More Than One Way to Index Your Portfolio