Index funds are a type of Exchange Traded Fund (ETF) that focuses on the performance of specific stock indices, as opposed to other types of ETFs that are based on oil or other commodities. Index funds are appealing to certain kinds of investors because they are inherently more stable than investing in specific stocks. Index funds spread the risk factor over the entire index, which in the case of the Wilshire 5000 amounts to, well, 5000 stocks. As such, large institutional investors like pension funds as well as older individual investors who are looking to reduce the risk in their portfolios often find index funds a preferable alternative to buying stock of individual companies.
Index funds mirror the performance of stock indices but since they are not actually composed of a “basket” of stocks, their share value does not always match that of an actual group of stocks from each index. The difference between the fund value and the actual total value of the index’s component shares is known as Tracking Error. To form an average index fund, investment management companies will form a Creation Unit usually comprised of 50,000 shares that are then offered to the markets. Most index funds today are managed by computer programs and are therefore able to offer investors reduced fees compared to more traditional, actively managed funds. On the downside, index funds do not, as a function of their nature, outperform the market because essentially they ARE the market. In this sense, index funds reduce both downside risk and upside risk. One way to get around this stumbling block is to invest in a tightly focused index fund based on a foreign stock index. For example, if the London stock market (FTSE) seems to be poised for significant gains relative to the NYSE, one might purchase shares in index funds like the FTSE 100 and the FTSE All-Share Index.
The concept of index funds was originated by Burton Malkiel in 1973 and expressed in his book “A Random Walk Down Wall Street”. Malkiel addressed the common complaint that most popular Mutual Funds were not performing better than the main stock market indices. Malkiel’s reply to the hypothetical rejoinder “of course, you can’t buy an index” was “It’s time the public can”, and shortly thereafter the Vanguard 500 Index, based on the Standard & Poor’s 500 index was born. From an initial asset value of $11 million, the Vanguard 500 Index fund rose to break the $100 billion mark in 1999, proving conclusively that investors will vote on a good idea with their wallets!