Index funds track whatever unmanaged stock indices the funds follow. There are index funds that follow the S&P 500, the Russell 2000, the Wilshire 5000, and many others. But that doesn’t mean that index funds are limited just to common stock indices. They can invest in bonds and other securities, too. These funds are categorized as passively managed funds because the funds’ portfolios reflect the individual indices. The other mutual funds we’ve discussed are considered to be actively managed funds because the fund managers pick the securities they think will outperform the market. They then buy and sell the securities in accordance with their projections. With index funds, the fund managers merely track the index. They don’t have to pick individual securities.

PROS AND CONS OF INDEX FUNDS.

One of the advantages of owning an index fund is a tax advantage. Since the funds track the market indices and aren’t actively managed, there is little security turnover, resulting in lower capital gains distributions. Thus, really, the shareholder would only have to worry about any interest or dividends that would be declared and passed through. With low turnover of securities, this also leads to lower costs for the fund. There are low transaction costs, as well as minimal research and investment-management fees.

Another possible advantage is that the funds are directly tied to the stock market. Many times, mutual funds that are actively managed will try to beat the market. And while some have done so, many have not. By investing in an index fund, you minimize your chance of being invested in a fund that performs worse than the market. However, that also means that you may miss out on some tremendous performances by other actively managed funds when they outperform the market. Many people believe that actively managed funds do outperform index funds during down markets. According to a recent study by the Schwab Center for Investment Research, over a period of 20 down markets between 1987 and 2000, the average actively managed large-cap mutual fund outperformed the average S&P 500 index fund only half of the time. Therefore, the average index fund outperformed the average actively managed fund half of the time, as well. This, of course, is not a case of one type of mutual fund doing so much better that you should forsake the other type of fund. Rather, sometimes a nice mix of actively managed funds and an index fund may be a good fit for your financial objectives.

As with any type of investment, there are limitations to index funds. One is that because the funds’ portfolios mirror the market indices, some of common stocks’ better performers’ returns may be undermined by other, lesser-performing assets. Since the funds are passively managed, the fund managers wouldn’t be selling off some of the stock that they don’t see as performing well. They would remain in the stock because the fund is an index fund. Also, the shareholders would lose any type of stock selection they desired. Actively managed funds that focus on a certain sector may be more appropriate for those investors who want to concentrate more in one area, instead of the market as a whole.

Index fund shareholders are also subject to market risk. When the stock market is doing very well, so will the index fund. However, when the market is doing poorly, or the country is experiencing a bear market, the index funds will also perform poorly. This is because the portfolios reflect the indices and will remain invested, whereas other actively managed funds may be holding some of their assets in cash or interest-bearing securities during this down time.