An index fund does not pick and choose its investments, but instead holds all of the stocks or bonds on an index.
So what’s an index? Basically, it is a list of investments. For example, the S&P 500 is a roster of the 500 largest U.S. companies with publicly traded shares. Each stock’s weight on the list is usually determined by its overall market value. For example, in early 2014, tech giant Apple Inc. counted for about 3% of the S&P 500, whereas Avon Products was less than .05%. Likewise, an S&P 500 index fund would hold 3% in Apple and .05% in Avon.
Why choose an index fund? After they charge their annual management fees of roughly 1%, most fund managers can’t beat their fund’s benchmark index over a long period. Index funds, on the other hand, usually carry very low fees (often less than 0.2% per year) and reliably deliver the market’s average performance. In other words, by aiming for mediocrity, you in fact give yourself a good chance of beating most other investors.
Do some active funds beat index funds? Absolutely. The trouble is, it is very hard to predict in advance which funds will be those top performers.