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Broad-based index funds usually do not trade as much as funds that are actively managed so they typically generate less taxable income.
There are many different types of indexes that track different kinds of companies. The biggest and most famous of these are:
• The S&P 500, which is an index of the 500 companies that are among the biggest and best companies in America. Just think of a big American manufacturer such as Ford Motors, Black & Decker, Hershey, Deere, Marriott, Wal-Mart and Gillette and you'll find them in the S&P 500. In fact, the S&P 500 is often used as a sort of a benchmarking for the entire stock market. So if it rises 5%, people will say that the market has risen 5%. Historically, the return of the S&P 500 has been around 10-11%, which is pretty good. The key here is to hold on for the long term. If you get nervous during a downturn and sell, you'll probably miss the recovery.
• The Wilshire 5000 - This index includes nearly every American stock both large and small. It got its name from the fact that at one time there were 5000 such companies. It now actually includes the stocks of 6500 companies, which is why it's often called the "total market" index.
• The Dow Jones industrial average. This is the average of 30 of the U.S.’s largest companies such as Wal-Mart, Microsoft, McDonald's and Coca-Cola. It is, without question, the most famous of all indexes and is often referred to as just "the Dow". It is also more than 100 years old making it America's oldest index.
Index funds don't always come out ahead in any given year. In fact, they usually fall somewhere in the middle of the pack. That's because by definition they provide an average market return – no more and no less. However, over the course of 10, 20 or 30 years they move to the top so that while they return only an average profit in the short term they will deliver above-average returns in the long run.
Frequently asked questions about index funds
Q. Which index funds have the lowest fees?
A. Index funds have expense ratios that are the lowest in the industry at 0.05% and 0.16%. Given these numbers it doesn’t make much of a difference which fund you choose unless you are making a substantially large investment such as $100,000 or more.
Q. Which index funds pay dividends?
A. Most index funds do not pay dividends as they include stocks that don’t pay dividends. So there are no dividends to pass on to shareholders. If it’s important for you to earn dividends, you will need to choose special index funds such as Vanguard High Dividend Yield Index Fund or the Vanguard Dividend Appreciation Index Fund.
Q. Who manages index funds?
A. Since the goal of an index fund is to mimic the behavior of a certain index such as the S&P 500, no one actively manages them. In fact, they are called passively managed funds. The money that goes into an index fund is automatically invested proportionately into individual bonds or stocks based on the percentage of their market capitalizations. For example, if IBM represents 1.5% of the S&P Index then $1.50 will automatically go into IBM stock for every $100 invested.
Q. Where to purchase index funds?
A. You can just go to Vanguard to buy a Vanguard fund. You can also open accounts and buy index funds through brokerages such as E*TRADE, Schwab, Ameritrade, Scottrade or Zecco. Getting started with any of these brokerages is about the same. You sign up online, provide your checking account information and then begin buying.
Q. What are index funds and ETFs
You've already what an index fund is. An ETF or Exchange-traded Fund is an investment fund traded on stock exchanges, much like stocks. Most ETFs track an index, such as stock index or bond index. By the end of 2015, ETFs offered 1,800 different products that covered almost every conceivable niche, market sector and trading strategy.