Index funds

Index funds are designed to produce the same return that you'd get if you owned all the stocks in a particular index — such as the Standard & Poor's 500-stock Index or the broader Wilshire 5000 Index, which includes all of the stocks traded on U.S. markets.

Index funds are popular in bull markets because the performances of the major stock indexes are typically strong, increasing the value of the fund. They may be less attractive in bear markets when the value of the index may drop.

Pros and cons

Investing in an index fund can eliminate having to decide among specific stock or bond funds and may provide a balance to other, more narrowly focused investments. They are typically cost-efficient investments, since they usually have lower expense ratios than actively managed funds. Plus, because index funds do not buy and sell investments as often as actively managed funds, they pay out fewer capital gains distributions — making them tax-efficient investments.

But it's also true that because most indexes are weighted, giving more emphasis to the largest or highest priced securities, a few components of the index can have a major effect — positive or negative — on the performance of the index, and the funds that track it.

Active or passive
Mutual funds may be actively or passively managed. In an actively managed fund, the manager decides what to buy and sell and when to make those trades. In a passively managed fund, such as an index fund, the fund holdings change only when the securities in the underlying index change. This means that, in general, an index fund's holdings will change much less frequently than those of an actively managed mutual fund.

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