An index fund allows you to enjoy the good parts of a mutual fund, with little or none of the bad, by buying stock in all the companies of a particular index and thereby reproducing the performance of an entire section of the market. An index fund builds its portfolio by simply buying all the stocks in a particular index -- the fund buys the entire stock market, not just a few stocks. The most popular index of stock index funds is the Standard & Poor's 500, but there are index funds that track 28 different indexes, and more are added all the time.
An S&P 500 stock index fund owns 500 stocks -- all the companies that are included in the index. This is the key distinction between stock index funds and "actively managed" mutual funds. The manager of a stock index fund doesn't have to worry about which stocks to buy or sell -- he or she only has to buy the stocks that are included in the fund's chosen index. A stock index fund has no need for a team of highly-paid stock analysts and expensive computer equipment that goes into picking stocks for the fund's portfolio. So the hard part about running a mutual fund is gone.
Investing in stock index funds is often called passive investing, since the funds don't use the same active management techniques as other funds. Passive investing has two big advantages over active investing. First, a passive stock market mutual fund is much cheaper to run than an active fund. Eliminate those analysts' salaries and an index fund can cut its costs tremendously -- and those savings can be passed along to investors in the form of higher returns.
The second main advantage of stock index funds is that they perform better than actively managed funds. Some investors find it incredible when they learn that most mutual funds are flops, at least when it comes to generating returns for their shareholders. In 1998, for instance, 85 percent of all mutual funds that were set up to beat the S&P 500 failed to meet that goal. When you think about it, that's an amazing statistic -- eight out of ten mutual funds didn't beat the market!
Of course, investing in a stock index fund guarantees that you'll never outperform the overall market, but less than 20 percent of all professional mutual fund managers master that task in any given year. Even armed with this knowledge, some investors are convinced that they can pick out one of the funds that will be in the rare 20 percent club -- easy in theory but actually much harder in practice. If you looked at lists of the top-performing mutual funds for the last several years, you won't likely find many of the same names on more than a few of them. It's not uncommon for a fund to have a "hot" year, but it's very uncommon for a fund to consistently turn in above average performance.