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What Is an Index Fund?

Chime Team • July 10, 2024

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Index Fund

An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to replicate the performance of a specific market benchmark, like the S&P 500, by investing in all or a representative sample of the stocks or bonds within that index. This approach is known as passive investing, as it doesn’t involve the active selection of investments by fund managers but instead follows the index’s composition​​.

The concept of index funds was first proposed in 1960 by Edward Renshaw and Paul Feldstein at the University of Chicago.¹ However, it wasn’t until the 1970s that the first practical index fund was created, with notable contributions from John Bogle, the founder of The Vanguard Group.

In 1976, Bogle established the First Index Investment Trust, which later became known as the Vanguard 500 Index Fund.² Despite initial skepticism, this fund paved the way for index funds to become a popular investment choice, offering investors a low-cost, diversified, and tax-efficient means of gaining exposure to broad market segments​.

In the 1990s index ETFs began to grow in popularity and by 2024, the total net assets of index funds and index ETFs grew to $13.3 trillion.³ To highlight the growth, index funds (ETFs and mutual funds) only accounted for 19% of long-term assets. By 2023, this number grew to 48%. In 2024, for the first time, passively managed funds controlled more assets than actively managed funds.

How do index funds work?

Index funds work by tracking a market index, a collection of stocks or bonds chosen to represent the performance of a particular segment of the financial market. Their main advantage is their broad diversification, which may reduce investment risk.

Because index funds hold multiple assets, the poor performance of a single stock or bond is less likely to significantly impact the overall investment. Additionally, index funds tend to have lower management fees and tax implications compared to actively managed funds, as their passive strategy requires less buying and selling of assets​​.

Index funds can play a crucial role in personal finance, serving as a foundational component in the investment portfolios of both beginner and experienced investors. They offer a straightforward way to invest in stock or bond markets without the need to research individual securities.

For those looking to save for long-term goals like retirement, index funds provide a way to participate in the potential growth of the financial markets while mitigating some of the higher risks associated with individual investments. However, investing in index funds doesn’t eliminate all risk. If the stock market dips or crashes, it’s still possible to lose money. Like any investment, index funds come with a level of risk.

In summary, index funds are a key financial tool that allows investors to achieve diversified exposure to various sectors of the economy through a single investment. Their low-cost, passive management strategy makes them an attractive option for people seeking to build or enhance their investment portfolios.

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1 Information from The Journal of Portfolio Management's "What is an index" as of June 19, 2024: https://www.pm-research.com/content/iijpormgmt/42/2/21

2 Information from Vanguard's "Our history" as of June 19, 2024: https://corporate.vanguard.com/content/corporatesite/us/en/corp/who-we-are/sets-us-apart/our-history.html

3 Information from the Investment Company Institute's "2024 Investment company fact book," as of June 30, 2024: https://www.icifactbook.org/

4 Information from Morningstar's "Index funds have officially won," as of June 30, 2024: https://www.morningstar.com/columns/rekenthaler-report/index-funds-have-officially-won

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