What Are Index Funds?

By Motley Fool StaffMarketsFool.com

The index fund may be the biggest invention in Wall Street history. From relative obscurity just a few decades ago, index funds grew to become more than a third of all stock fund assets under management.

What exactly are index funds, anyway? In this segment of Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss the differences between index funds and more traditional mutual fund investments.

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A full transcript follows the video.

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This podcast was recorded on Sept. 14, 2016.

Gaby Lapera: Jordan,I'm going to start with an extremely softball question. What is an index fund?

Jordan Wathen:Anindex fund is, technically speaking,any kind of fund that invests in an indexand isn't actively managed. An actively managed fund hiresportfolio managers and analyststo find good stocks and bondsthat they think will make great investments,and they generally seek to outperform the market, or outperform a benchmark. Index funds,on the other hand, they just buythe index. If you buy a traditional S&P 500index fund, likeVanguard's 500 index fund,it buys and sells all the stocksin the S&P 500. That's all it does. If a stock is removed from the S&P 500, then the fund sells it. If a stock is added to the index, then the fund buys it.

Lapera:Just for ourlisteners, in case you haven'tcaught on to this,there are these things called indexes,and they work just like an index in a book. They list everything that's in the book. The index listseverything that's in that particularindex, stock index, which is whyit's called the S&P 500 Index.

Wathen:Right. TheS&P 500 Indexgenerally holds 500 of the largestcompanies in the United States, or that trade on U.S. markets.

Lapera:Right. You weretalking earlier about mutual fundstrying to beat their benchmark. Typically The benchmark issome kind of index.

Wathen:Right,typically it is an index. It depends. Bonds have bondindexes, bond investors aren't trying to beat stocks. Andstock investors would hope that they could outperform bonds, generally, but they're not benchmarked to bonds.

Lapera:Can you name any othermore commonly knownstock indexesfor our listeners?

Wathen:TheS&P 500 is a large-cap index. It holds 500 of the largest stocksin the United States. On the other end of the spectrum would be, say, theRussell 2000, which holdssmall-cap stocksin the United States.

Lapera:Just so our listeners know, cap refers tomarket capitalization. A large-cap stockwould be a company whose market capitalization is above $5 billion. Of course, that figure variesdepending on who you ask. But around $5 billion is good enough for our purposes. Small cap is,obviously,a lot smaller. When I say a lot smaller, I mean, say, $200 million. It's a lot, lot smaller.

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