An index fund is a type of security whose value follows a measure, or index, of a specific segment of a financial market. The most common are stock index funds, which follow a particular stock market index, like the S&P 500. Although stock index funds are the most well-known type, index funds may follow other types of indicators. There are also bond index funds, commodity index funds, and index funds that attempt to replicate various segments of an industry, like real estate, or the economic health of a country, like the All Ordinaries Index, which attempts to replicate the state of the Australian economy. Some index funds even track indices tied to social responsibility or environmental concerns, like the NYSE Arca Environmental Services Index.
A stock market index fund may follow a global or world index, which represents a group of companies from various countries. The index fund may alternatively follow a national index of a particular nation, mirroring the state of the country's economy. Two examples of a national index are the Japanese Nikkei 225 and the British FTSE 100. Although the terms global index or world index might suggest that the index fund follows the global economy, that is not the case. Global or world index fund merely indicate that the companies in the fund represent many countries. An example of a global index fund is the Morgan Stanley Capital International (MSCI), which contains stocks from 1,500 companies with a global presence in 23 developed market countries.
Bond index funds follow specific corporate or municipal bond indices, like the Lehman Brothers Aggregate Bond Index, which includes government, mortgage backed, and corporate fixed-income securities. Other bond index funds sample short, medium, and long-term bond markets. Bond funds in general are a security that provides cash to a government or company in return for a security that has a specific maturity date. At maturity, the bond holder may cash in the bond for the face value plus interest.
Commodity index funds follow specific commodities markets and commodities futures. These index funds provide opportunities for less experienced investors to invest in a market that has a reputation for being complex, risky, and best left to professionals. An advantage to investing in commodities index funds is that, historically, commodities fluctuate independently of stock and equities because commodoties fluctuate in response to supply and demand. This provides an investor with a more diverse portfolio.
Although by definition an index fund is a passively managed security that follows a specific market index, some index fund managers are stretching the definition of index funds by adopting different indexing techniques, many of which require some degree of active management. Some index fund managers are taking a more active, hands-on approach by utilizing timing strategies and rules to more closely follow an index. Yet this approach may negate one of the primary advantages of an index fund: lower fees. Also, index funds outperform 80 percent of actively managed mutual funds. The goal of index funds is not to beat the index, as with traditional stock and equity funds, but to match it.