An index fund is a type of mutual fund that adjusts its holdings match the components of a particular asset-class or stock market index. For example, an S&P 500 index fund should consist of the same assets as the S&P 500 index, or at least a representative sample, represented in roughly the same proportions. Index funds closely track the performance of their underlying indices.
There are a number of advantages and disadvantages to investing in an index fund. The chief advantage of this type of fund is typically its performance versus managed funds. Another advantage is lower expense ratio; by using a public index to determine the makeup of a fund, fund managers can forgo expensive research costs. Index funds also tend to incur lower taxes, as they generally hold securities for longer terms than more aggressively managed funds.
One of the key disadvantages of index funds is that the components of an index tend to change infrequently. This can potentially expose the fund to greater risk in a sudden downturn. Furthermore, since index funds are designed to track broad swings of the market rather than collecting individual stocks that "beat the market", they may not be ideal for short-term investors.
