ETFs for the Long Run: What They Are, How They Work, and Simple Strategies for Successful Long-Term Investing

CHAPTER 4

Index Fund-amentals

It’s all well and good to say an ETF is an index fund that trades on a stock exchange, but unless you know what an index is and why it’s important, and what an index fund is, that description isn’t very helpful. So, first things first: indexes will be described and discussed in this chapter.

Indexes measure the direction and health of a financial market. Most indexes track stocks or bonds, some follow commodities, and some follow other financial instruments. Indexes can be very broad; some track the entire stock market. Others are extremely narrow and follow a particular segment of the financial markets. For instance, one index measures only steel company stocks.

An index fund is an investment company whose objective is to earn the same return as a particular market index minus costs. The classic index fund is comprised of all the components of an index, in the exact same weighting. Sometimes this isn’t possible, so the index fund creates an extremely close approximation. The key benefits of following this strategy are transparency and low cost.

Mutual funds follow one of two management styles, actively managed and passively managed. In addition to management style, all mutual funds have an investing style. This is outlined in the fund’s prospectus. Examples of investing styles include building a portfolio around small stocks, or international stocks, or biotechnology stocks or growth stocks. But management style is the first decision an investor ...