Stock indexes were created to track the overall performance of the stock market, or a sector of the market. Buyers who invest in stocks included in these indexes practice index investing. The goal of this kind of investing is to match the earnings performance of a specific index.
Stock indexes are simply lists of stocks. People cannot invest directly in an index. Investors can purchase mutual funds and exchange-traded funds (EFTs) that include all of the stocks listed in a particular index.
There are a variety of popular indexes that investors like to duplicate in their portfolios. These include the S&P 500®, the Dow Jones® Industrial Average, the NASDAQ-100® and the Russell 2000®. Investors choose the index they want to follow, and find a fund that mirrors that index.
Index investing is simpler than purchasing individual stocks. Investors do not have to complete any complex analysis to determine which stocks to buy. The fund automatically buys the stocks listed in the index.
Mutual funds and EFTs are bought and sold differently. Mutual funds trade over the counter and are not listed on a stock exchange. As a result, a brokerage account is not required to buy mutual funds. Mutual fund share prices are calculated once a day. This price is called the net asset value (NAV). Mutual funds generally have a minimum investment requirement.
Since the index fund manager does not have to research which stocks to buy, index mutual funds generally have lower operating fees than other mutual funds. Some mutual funds used in index investing charge the buyer a upfront commission called a load. No-load funds are also available that do not have upfront commissions or other sales charges.
All EFTs, including those used for index investing, are traded on a stock exchange like other stocks. EFT shares do not have an NAV calculated each day. EFT share prices change throughout the day based on trading volume.
A brokerage account is required to purchase EFTs. Stockbroker commissions apply to all EFT trades. Unlike mutual fund shares, EFTs can be bought on margin and sold short. Investors can determine the amount of shares they want to buy. There is no minimum investment required to buy EFT shares used for index investing.
Investors can compare the annual cost of mutual fund and EFT index investing. Each fund charges annual operating and other fees. These fees are called the fund’s expense ratio. Generally, investors prefer funds with lower expense ratios.