What are index mutual funds? Your questions answered

Even if you’re new to investing, you’ve probably heard of mutual funds as an opportunity to diversify your portfolio. But what about the different kinds of mutual funds? Depending on your risk tolerance and financial goals, some types may be the perfect fit while others might be outside of your comfort zone.

By better understanding what each can and can’t do, you’ll have the tools you need to build your ideal portfolio. In this post, we’ll answer some common questions about index mutual funds , typically a passively managed fund that aims to mimic the performance of an entire market index (like the Nasdaq 100 or the S&P 500) by being composed of most or all of the stocks that make up the index.

Before we dive into how these funds work, let’s first take a closer look at what they are. As we mentioned above, an index mutual fund is typically made up of most or all of the stocks in a particular index, such as the Dow Jones Industrial Average or any of the other broad market indices covering different types of companies, industries or sectors.

The index on which the mutual fund is based is known as the target index and the mutual fund looks to track its performance. That means if the index goes up or down, the value of the index mutual fund is likely to perform similarly on a percentage basis.

The volume and variety of securities in each of these indices mean index mutual funds add instant diversity to any portfolio. They also tend to be less volatile than individual stocks. By their very nature, because index funds seek returns that match an index, they can produce fairly predictable results over time.

The usual motivation for investing in an index mutual fund is to hopefully take advantage of broad-based bullish activity across stocks in the fund’s portfolio. Certainly, stocks within the index fund may exhibit bearish tendencies at any given time, but you want the overall basket of stocks to demonstrate upward momentum over time.

You may be bullish on a particular sector measured by a specific index, or on the broader markets overall. So be certain to choose the right index mutual fund to best match your sentiment. Regardless of intention, the market can always behave counter to your analysis.

Yes, like other mutual funds, index mutual funds have fees. However, because they’re passively managed, the expense ratio (ongoing fees associated with owning mutual funds) tends to be lower. Not having to pay for a fund manager’s time and fewer transaction costs keep those expenses lower. 

Just like any other investment, index mutual funds have benefits and potential risks. Weighing both against your own financial goals can help you make the right choice for your portfolio.

Because index mutual funds are composed of many different securities, your investment, in essence, is instantly diversified. 

Index mutual funds typically track the returns of market indexes, which often means more reliable returns on your investment over time. Keep in mind, though, this kind of investment also introduces a level of risk (more on that in the cons section).

Because index mutual funds are typically not actively managed, ongoing fees tend to be lower.

Index mutual funds can quickly diversify your portfolio, but that doesn’t necessarily make them a safe bet. You always assume some risk when investing in the stock market. Index mutual funds move with the market, which means if the stock market goes down, your fund goes down. 

The life of an investor is full of decisions: Where do you put your money? How long do you keep it there? The most difficult part is that there is no right (or wrong) answer. The good news is, you’re in control. Get smart about the markets and decide what will best serve your own financial goals. If a diverse portfolio that requires no active management checks those boxes for you, consider adding index mutual funds to your financial mix.