Here are the ground rules for what the IRS will allow you to do.
What is an index fund?
An index fund is a mutual fund built to match the stocks of a market index, such as the Russell 2000 or the S&P 500. An index fund’s portfolio of stocks is the same as the index it tracks, and when prices of stocks in the index decrease, the value of the index fund decreases. Index funds trade on all the major exchanges, and each one has its own ticker symbol.
Many investors use index funds as a way to diversify their portfolios, which is a form of passive investing. Buying into an index fund gives you broader exposure to a group of companies as opposed to buying shares of stock in one company.
Building a diversified portfolio is one of the main strategies of investing, and index funds represent a multitude of sectors within the index they track. A basket of underlying securities in an index fund can protect you from major losses, if the price of one of those stocks dramatically falls.
Index funds typically have lower fees than actively managed mutual funds. Index funds require little to no trading activity since the funds track a broader index while actively managed funds continuously add or remove securities from their portfolios.
The underlying securities of an index fund always remain the same unless an index removes one of the securities from its index. Many index funds require a minimum investment and usually charge front- or back-end fees.
Want to learn how to invest in index funds like the pros? Read more.
Index fund example
Companies such as Charles Schwab and Vanguard offer index mutual funds that track the total return of market indexes. For example, Charles Schwab offers the Total Stock Market Index Fund, which tracks the entire equity market based on the Dow U.S. Total Stock Market Index. Another example is the Wilshire 5000 Index Investment Fund, which tracks the performance of 6,700 stocks from the Wilshire 5000 Index.