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Key Terms Mentioned

Opens the scrolled simulated dialogImportant Disclosures

Index Mutual Funds

An index mutual fund is benchmarked to replicate the return of its underlying index. To create a similar portfolio on your own, you'd have to buy all the securities in a particular index and hold them in the same proportion, or weighting, as they are included in the fund. If that sounds to you like a lot of work and an expensive proposition, you're probably right.

You can find index funds linked to every well-known stock market index that tracks large, mid-cap, and small companies. There are also indexes that mimic subsets of each major index, some of them quite narrowly focused. You can also find strategy indexes that allow you to invest for specific goals, such as low volatility or high dividend return. Keep in mind that when you invest in a fund, you're not literally investing in an index, and fees and expenses will impact your return.

Additionally, you might choose an array of bond market indexes, commodity indexes, and indexes that focus on international securities, which all have different risk profiles. In fact, you can construct a broadly diversified portfolio by allocating your investment principal entirely to index funds.

Fund Appeals

Index-based funds are popular because that they often cost investors less than actively managed funds do. There's less portfolio turnover, which leads to fewer trading costs since the index fund portfolio changes only when the underlying index changes. In some cases, that's only once a year. Some indexes may even wait several years to make a change. In addition, fund management fees can be considerably less costly for index funds because they don't typically employ active managers to choose securities.

Of course, not all index funds tracking the same index have the same expense ratios. Some funds have higher expense ratios than others. Fortunately, this information is available in each index fund's prospectus, on the Capital One Investing website, and on the fund company's website. Since paying fees can lower your return, it may be good to seek out funds with low expense ratios, but don't let that be your only deciding factor.

Fund transparency is also an attractive feature. What transparency means is that you have a clear idea of what the fund owns at all times and what percentage of its portfolio is allotted to each holding. In an index fund, you probably have a very good idea of this. In contrast, an actively managed fund is required to publish its holdings just four times a year, though the holdings may change much more frequently than that.

A Word of Caution

Index mutual funds that track a broad index of holdings that span multiple sectors may expose you to fewer risks than if you owned just a few stocks or other individual securities. This is the result of diversification. If you choose to invest in focused index funds, known as sector funds, it will narrow the scope of your investment to a limited number of companies in one industry and could make your portfolio less diversified. This can lead to price swings (good or bad) that are more volatile than the overall stock market. Diversification is an important way to help manage risk, yet it doesn't guarantee a positive return or protect you from losses in a falling market.

When an Index Goes to Market

Most mutual fund families build an index fund to replicate the index it tracks. Replication means buying all of the securities in the relevant index in the appropriate weight and trading only when the index components are updated.

In contrast, enhanced index funds can weight undervalued stocks more heavily, include a larger proportion of securities in higher-performing sectors, or use other investment strategies to try and achieve a better return than the index it tracks. While enhanced index funds may offer an opportunity for higher returns, they typically expose you to the risk of greater losses than their more traditional index funds.

Additionally, some enhanced index funds use complex mathematical models to identify the strongest securities in the index or look for price inconsistencies it can potentially capitalize on. In that case, the fund manager's goal may be to slightly outperform the index. They'll use an active management strategy to try and achieve a return that's anywhere from a fraction of a percent to two percentage points higher than the index return.

On another front, Quant funds get their name from the quantitative investment style its managers follow. The goal is to beat an underlying index by relying on statistical analysis to decide which securities might outperform others. For example, instead of buying all the stocks in the S&P 500, a quant fund manager might select a limited number - perhaps 250 - that the research team indicates will provide a higher return than the index as a whole.

Each index fund's prospectus explains its approach to selecting investments, in addition to its expense ratio, historical returns, risk profile, and other required information about the fund. And regardless of its strategy, it's possible to lose all or part of your investment.

The Pop Effect

Index funds that track a well-known index, such as the S&P 500 or the Russell 2000, may own a significant percentage of the floating shares of each company in the index. As a result, stocks being added to the index have historically enjoyed a positive, if temporary, jump in market value. That's also been true on the opposite side, as prices of stocks being dropped from the index have fallen, as well.

This happens because all of the funds tracking the index must update their portfolios, which increases demand for the stocks getting added to the overall index, while the stocks getting dropped from the index will see more selling of its shares. However, there's no rule requiring instant updating of a fund portfolio, and the changes may actually occur over several weeks. This tends to reduce the effect on dramatic price swings.