An index fund is a type of managed fund (also known as a 'mutual fund') which tracks a popular financial index, like the Dow Jones Industrial Average or Australia's ASX 200.

Let's slow that down...

Managed funds

A managed fund is a pool of investors' money which is managed by a professional investment company. The company pools investors' money into a trust, from which they can invest the money and take a fee.

So far, so good.

An Index

An "index" is a collection of shares, bonds or some other 'financial asset'. For example, the S&P/ASX 200 is the 200 largest companies on the Australian share market, while the FTSE 100 index groups the 100 largest stocks on the UK stock exchange, and the Dow Jones Industrial Average includes 30 large companies from American markets.

Who chooses the index?

These 'indices' are created and maintained by big finance companies, like Standard & Poor's (S&P) or MSCI.

How do index funds work?

Let's imagine you wanted to buy a tiny piece of every company in the ASX 200 or a tiny slice of every bond on the US bond market, how would you do it?

You could go and buy each one, but that would take time and cost a lot.

An easier way would be to buy into an index fund which does it for you. The index fund company will take your money, pool it with everyone else's money and buy a piece of every stock or bond in the index.

Because computers and not humans do most of the legwork in an index fund, they are sometimes called passive investments. Meaning, a professional does not play an active role in the investment process.

And since computers are doing the work, passive index funds are often much cheaper than actively managed funds.

How to judge an index fund

When you are deciding which index fund to buy, some of the things you can consider are:

  • The size of the index fund, bigger index funds can often use their scale to run more efficiently
  • The exposure of the index. For example, some index funds only buy large stocks, some will buy small stocks, others buy and sell bonds, or property. Make sure you know what exposure you are getting.
  • If the index fund can be bought via an exchange-traded fund (ETF) or if you have to apply to the index fund company directly. ETFs can bought in a stockbroking account.
  • The cost. Some index funds have a yearly management fee of 0.04% (or less) while others can be quite expensive (2% or more). Fees can make a big difference to your investment returns over many years.

These are just some of the things you can use to compare index funds. However, the best thing for you to do might be to speak to a professional financial adviser or licensed expert.