by George Tucker

Created on: January 31, 2010   Last Updated: February 01, 2010

Index funds, low-cost mutual funds designed specifically to track an underlying index, are extremely useful products for retail and institutional investors. This article will explain the advantages of index funds, and how a smart investor selects among mutual funds.

What is an Index Fund?

An index fund is a type of mutual fund (or exchange-traded fund, ETF) that tracks an underlying financial index. The most commonly-tracked indices are such well-known names as the Dow Jones Industrial Average, the S&P 500 and the Nasdaq. Other index funds track less well-known indices as the Wilshire 5000 or the Russell 2000.

Some index funds track stocks based on their size: small, medium, large or giant. Other index funds track specific industry sectors, such as basic materials, financials or consumer goods. Index funds may track a type stock like value or growth.

Finally, some index funds are geographically specific. The company iShares manages exchange-traded funds that track the stock performance of nations including Germany, Japan and even Singapore.

Investors use index funds to capture the performance of an entire market sector, stock index or nation. But why do index funds even exist? What is their use to investors?

Index Funds and Efficient-Market Hypothesis

Index funds are most useful for those investors who follow efficient-market hypothesis (EMH). This financial theory asserts that stocks and other publicly-traded assets are priced according to all known information. Investors who follow EMH believe it is impossible to consistently outperform the market except through luck.

Academic studies of actively-managed mutual fund performance seem to support EMH. Investment guru William Bernstein devotes several chapters of his outstanding The Four Pillars of Investing to demonstrating the connections between EMH and real-world performance.

What does this mean to investors? Simply this: it is not possible to consistently outperform the market. Therefore, an investor's total returns will not exceed the returns of the market minus expenses. Therefore, proponents of EMH recommend low-cost, highly-diversified index funds for optimum performance.

Tips for Choosing an Index Fund

Investors examining index funds should pay attention to several core criteria. These include:

*Expenses: As William Bernstein and others remind us, "Performance comes and goes, but expenses are forever." Since returns are equal to market returns minus expenses, the lower an investor's expenses, the

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