Catherine Gordon: Perhaps you've heard about index mutual funds but need to know a little more before choosing this type of investment. Let's take a look at how they work to see if index investing is right for you.

An index fund seeks to chart the returns of a certain market segment or benchmark, such as the Standard & Poor's 500. Index funds hold the same securities—or a representative sampling—as the index. They may consist of stocks, bonds, or other securities, but the goal is the same—to produce returns based on the performance of that fund's index.

So why would you consider choosing an index fund over other investments?

The answer is pretty simple—diversification at low cost. Index funds typically have lower costs than actively managed funds because they're … well, not actively managed.

Since the fund simply seeks to chart a particular index, it doesn't have to pay a fund manager to constantly buy and sell securities to try to beat the market. Lower costs mean more of the returns are passed on to you.

So if you assume a level playing field—an index fund versus a similar active fund—the index fund probably is going to be ahead of the game.

There are other benefits to index investing. There's less turnover of securities in index funds, so they generally distribute fewer taxable gains than active funds.

Less turnover also means less guesswork, since you'll have a good idea of which securities the fund contains. And less guesswork just might mean you can spend less time choosing a fund and more time tending your garden or watching the ballgame.

It's not that there aren't good actively managed funds out there, but an index fund takes a simpler approach.

It's also important to note that all index funds are not created equal. Many investment companies charge a sales load or other fees to buy index fund shares. And buying them through a broker probably will cost you a commission for the trade.

Certain index funds run the risk of tracking error, when the fund's return differs from its index. This can be caused by many factors, including the fund's expense ratio or transaction costs. These are good reasons to choose a fund from an investment firm that has experience and expertise with the "ins and outs" of indexing. It's a profession, not a hobby.

You might ask: What's the best way to get started with indexing? A good first step would be to look for a fund that seeks to track a total market index, be it stocks, bonds, or a combination of both. 

You also could consider owning an exchange-traded fund that seeks to track an index, though you may pay a commission to buy or sell an ETF.

And just as a single mutual fund diversifies your investment dollar, there's nothing wrong with owning active funds to complement your index holdings.

It's not that there aren't funds with managers who sometimes beat the market, but it takes a lot of time, effort, and research for them to do so. Somebody has to pay for this, and it'll probably be the fund's shareholders.

Look at it this way: The actively managed market is like a good action movie—where's the market moving; what's the next IPO; who has the hot stock, and so on. It might be exciting, but it also might be a little tougher to stomach.

So while indexing may seem to be a yawn, it does mean the fund will always seek to provide the full market return, minus expenses.

And ultimately, low expenses are a good way to differentiate among funds. That's why we think that indexing is the investment professional's option for the nonprofessional investor.

You can learn more about indexing at Vanguard.com, including how to compare index and active investing.

Thanks for watching.

Notes:

For more information about Vanguard funds, visit Vanguard.com to obtain a prospectus, which contains investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

Vanguard ETF Shares can be bought and sold only through a broker (who will charge a commission) and cannot be redeemed with the issuing fund. The market price of Vanguard ETF Shares may be more or less than net asset value.

Past performance is no guarantee of future results.

All investments involve risk. Investments in bonds are subject to interest rate, credit, and inflation risk.

Foreign investing involves additional risks including currency fluctuations and political uncertainty.

The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

S&P 500® is a registered trademark of Standard & Poor’s Financial Services LLC ("S&P") and has been licensed for use by The Vanguard Group, Inc. The Vanguard mutual funds are not sponsored, endorsed, sold or promoted by S&P or its Affiliates, and S&P and its Affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding units/shares in the funds.

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