HOW INDEX FUNDS WORK
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Investment markets are very complex. To build a
portfolio of securities that consistently outperforms all other
portfolios is virtually impossible. However, most portfolios do
underperform the indexes used to "measure the market." Since index
funds own the stocks that make up the index, they will perform as
well as the market that the index measures. Most investors would
like to boast about "beating the market." They hate to admit their
portfolio did not even match it. Using an index fund gives these
investors the best chance to at least match the market. However, if
their index underperforms another index, their index fund can be
expected to do likewise.
The advantage of index funds is that they keep pace
with the market. Their downside is that they cannot outperform the
market. Some fund managers buy the top-performing stocks in the
index instead of all the stocks in the index in an attempt to "beat
the market." Such funds, however, are not considered true index
Even index funds that use the same index can be
structured differently. Some allocate their holdings evenly among
the index stocks. Others allocate a greater proportion to bigger
companies than smaller ones. That is why different funds that use
the same index have different returns.
Their competitive returns and lower management fees
have made index funds popular for years.
Some other characteristics that appeal to
investors will be discussed next.