In addition, index funds are passively managed, making them cost- and tax-efficient investments. Instead of the fund's managers deciding what to buy and sell and when to trade, as they do in an actively managed fund, an index fund's holdings change only when the securities in the underlying index change. Because most index funds update their portfolios as infrequently as once a year or less, they pay out fewer capital gains distributions than a fund that changes its portfolio regularly. Furthermore, operating expenses are reduced because less day-to-day administration and oversight is required.
Not all index funds are constructed in the same way. Though most practice replication and buy shares in all of the holdings of a particular index, this is not the only approach.
Enhanced funds, for example, purchase only a select number of securities within the index's portfolio with the objective of producing a slightly higher return than the index. However, enhanced funds aim to beat the index by no more than two percentage points because any wider spread would classify them as actively managed funds. An enhanced fund generally identifies undervalued stocks, or uses other investment strategies like buying derivatives, to achieve a higher return. As with any investment, their potential for higher return signifies greater risk.
Like enhanced funds, quant funds (short for quantitative analysis) also attempt to beat the performance of an index, though this type of fund uses statistical analysis to select a portion of an index's holdings. Specifically, the fund holds the components expected to perform better than the index as a whole.
Diversification does not assure a profit, or protect against loss, in a down market.
Investors should consider the investment objectives, risks, charges, and expenses of a mutual fund carefully before investing. A prospectus contains this and other information. A mutual fund prospectus is available through www.scottrade.com or through a Scottrade branch office. The prospectus should be read carefully before investing.