What is an Index Fund

An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities to purchase and is therefore a form of passive management.

The lack of active management (stock picking and market timing) gives the advantage of lower fees and lower taxes in taxable accounts. However, the fees will always reduce the return to the investor relative to the index. In addition it is impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the 'tracking error'.

Index funds are available from many investment managers. Some common indices include the S&P 500, the Wilshire 5000, the FTSE 100 and the FTSE All-Share Index. Less common indexes come from academics like Eugene Fama and Kenneth French, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama French Three Factor model is used by Dimensional Fund Advisors to design their index funds. Robert Arnott and Professor Jeremy Seigel have also created new competing fundamentally based indexes based on such criteria as dividends, earnings, book value, and sales that are being deployed in ETF products.