"Index fund" describes a type of mutual fund or Unit Investment Trust (UIT) whose investment objective typically is to achieve the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index, or the Wilshire 5000 Total Market Index. An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in a selected index. Some index funds may also use derivatives (such as options or futures) to help achieve their investment objective. Some index funds invest in all of the companies included in an index; other index funds invest in a representative sample of the companies included in an index.
The management of index funds is more "passive" than the management of non-index funds, because an index fund manager only needs to track a relatively fixed index of securities. This usually translates into less trading of the fund’s portfolio, more favorable income tax consequences (lower realized capital gains), and lower fees and expenses than more actively managed funds.
Because the investment objectives, policies, and strategies of an index fund require it to purchase primarily the securities contained in an index, the fund will be subject to the same general risks as the securities that are contained in the index. Those general risks are discussed in the descriptions of stock funds and bond funds. In addition, because an index fund tracks the securities on a particular index, it may have less flexibility than a non-index fund to react to price declines in the securities contained in the index.
Another type of investment company that attempts to track the performance of a market index is an exchange-traded fund (ETF). ETFs are legally classified as either UITs or open-end companies, but they differ from traditional UITs and open-end companies in a number of respects. For example, pursuant to SEC exemptive orders, shares issued by ETFs trade on a secondary market and are only redeemable in very large blocks (blocks of 50,000 shares, for example). ETFs are not considered to be, and may not call themselves, mutual funds.
Before investing in an index fund, you should carefully read all of the fund’s available information, including its prospectus and most recent shareholder report.