Such a fund typically invests in stocks, and tracks the performance of a specific stock index, such as the S & P 500. As index funds are mainly run by computers, the fees (and taxes, if relevant) for such funds are lower since there is little to no active management by humans. In addition, since the management is automatic, theoretically the inefficiencies involved in stock selection are avoided.
Equity index funds do not wax and wane with the stock market. Rather, an annual snapshot – usually occurring on the date a person initially invests in the fund – determines the growth. For example, if the fund follows the S & P 500 index, and the S & P is up compared to where it was when the investor entered the fund, the investor will gain proportionately.
Besides being more efficient and avoiding the ups and downs of the market, in these funds securities are not sold, so there are no capital gains. If the fund is part of a retirement vehicle such as an IRA this is irrelevant, since one wouldn’t be taxed on the capital gains anyway. But this is generally considered an advantage.
What are the disadvantages of equity index funds? Despite the theory that it should be more efficient, it doesn’t not always track the index it is following well. This is called a tracking error and can cause lower returns than it otherwise should have.
In addition, it cannot perform the target index. While managers of regular mutual funds attempt to – and often do – outperform the indices, like the Dow Jones Industrial Average, an equity index fund can only grow as much as its index. This means potential money loss for the investor.
While index funds cost less to run and are simpler than other mutual funds, the inability to outperform the index and tracking errors are serious problems. I once had an equity index fund for several years, and most of the time I made nothing the entire year. Since I had bout $20,000 sitting in the fund, and even my annuities were doing better, this was quite distressing and I finally told my financial advisor I wanted out.
So, are they a good retirement investment? In my opinion, no. Deal with the stock market ups and downs and put most of your money into regular stock mutual funds, and your money will bring much higher returns.