In 1975, John Bogle of the Vanguard group had an idea: make a mutual fund to track the S&P 500. To do this, all they had to do was buy the stocks in the index in the correct proportions. The buy / sell decisions could be made by a computer. No expensive MBAs, no trips to wine country or Aspen to check on company management, just track the index. A typical index fund has a cost overhead of about ½% per year.
In his book Common Sense on Mutual Funds Bogle wrote an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund due to the significantly lower management costs. In fact, he underestimated. In the '90s, the average mutual fund under performed the S&P 500 by 3.4% per year.
Today, index funds have become quite popular with investors (if not stock brokers) due to their continued success at delivering consistent excellent returns. Since index funds have become so popular, there are now dozens of them. Some of these funds track the S&P 500 or the Dow; as we've seen these two indexes track each other reasonably closely, so there's not a huge difference between them. Others track the NASDAQ, the various Russell indexes, the Nikkei, etc. There are a lot of choices with regard to volatility and risk / reward.
What's the main drawbacks? First, these investments are boring. You have to be willing to buy them and ignore them. Next, markets still fluctuate. Even the S&P 500 has down years, and if you have to sell in a down year this makes a huge difference in your success. Finally, like all funds, your sell order is executed at the end of the day. So you buy and sell at the least favorable price to you, meaning it effectively costs about 1% to get your money in or out. Of course, without question these shares should be bought on-line. If you pay a broker 3.5% sales commission to put your money in an index fund, I seriously suggest you get your head examined.
As wonderful as they are, index funds are now a bit out of date. There's now a better investment available which does the same thing at a lower cost, it's called:
An Exchange-Traded Fund is a relatively new idea, a new way to bundle securities together and get our money. Basically, a large trading house buys a groups of stocks that mimic an index, and place the stocks into a trust. Then the trading house sells shares in the trust. Since the trust pretty much just holds a bunch of stock certificates, it's typically a large bank and the fund maintenance fees are especially low, typically on the order of .1%, thirty times less than a typical mutual fund. What you buy is shares in the trust, and you buy them just like you buy any other share: you can buy them on-line at a discount brokerage house for under $15 per transaction, and your buy / sell orders are executed immediately at the current price, not at the end of the day at the price which is worst for you.
The drawback? If you want to set something up where you have $100 deducted from your paycheck and deposited automatically into the fund, the $15 or so per transaction will eat your money up. For regular small contributions, a regular index fund is highly preferred: most of these take small additional contributions with no cost overhead at all, save the end of trading day scam. But, if you have a couple thousand dollars or more to invest, ETFs are the cheapest, fastest, most liquid way to get in and out of an index fund. Since they are traded throughout the day, the per share price on an ETF can drift away from the underlying asset price. In practice this never happens by much. If the price gets off by a little bit, the fund creator's computer will notice. In this case the institution that created the fund typically can add stock shares to the trust and create more ETF shares, or redeem ETF shares for shares in the underlying stocks. The computer will create or redeem ETF shares until the price gets back in line, and make a bit of money at it. This is called ETF price arbitrage.
The advantage? If you're moving a couple thousand dollars at a time or more, this is the cheapest way to get your money in and out of the market. Since it's just another stock, you can also do all the normal stock things: stop or limit orders, sell short, buy on margin, day trade. I don't particularly recommend any of these things as a smart way to handle your life savings, but you can do it.
Plus, the common ETFs have very sexy names. S&P 500 shares are called SPDR, Spiders. Dow Industrial Average is DIA, Diamonds. You can have Spiders, Vipers, Diamonds, Cubes, Holders in your portfolio. That should make for some good party talk. There are currently a couple hundred ETFs available tracking various US and international indexes. These are very popular now and getting more popular every day. At the time of this writing, there are about $250 billion in ETFs, and this number is increasing by about $500 million per day.
When a company in your index fund pays a dividend, a typical index fund will reinvest the dividend. In an ETF, the dividend will be deposited in your brokerage cash account.
ETFconnect (link in the Google Ads above) is a great source for more info. Fool.com is a great group of guys who just incidentally happen to agree with me.