While the stock market is made up of thousands of individual stocks, many value the overall strength of the combined market through the use of stock indexes. The S&P 500 is a broad look at the market that includes 500 large companies in its calculation. Investors look to this index for the best insight into the health of the market, and some use it as the basis for their investments in an S&P 500 Index fund.
Different types of index funds exist, but all structure their performance on the same concept. The idea of an index fund is to provide annual returns comparable to the returns of the stock market index itself. In the case of an S&P 500 index fund, the end-of-year returns should nearly be equal to actual annual performance of the S&P 500 index. In reality, the returns are not exactly identical, but they are close enough to give investors returns that equal the overall stock market.
One type of S&P 500 index fund is a mutual fund. These are managed funds that buy and sell real corporate stock to mirror the real stocks included in the index. Prior to the explosion of exchange-traded funds (ETFs) in the 1990s, mutual funds were the easiest way to receive nearly the same returns of the overall stock market. However, despite the gross returns of a mutual fund nearly equaling the index, the actual portfolio performance is less than this. The fund's managers charge a percentage for their work, which varies but is usually one or two percentage points. Additionally, the fund's transaction costs for buying and selling stock are passed on to the fund's investors. In the 1990s, the average S&P 500 index mutual fund returned 3.4 percent less per year than the index itself due to these additional expenses.
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Today, investors can participate in the returns of the S&P 500 index without buying into managed mutual funds. ETFs trade on the stock market like regular stock. They mirror indexes as well as sectors, foreign markets and commodities. The most popular S&P 500 index ETF as of 2011is the SPDR S&P 500, with ticker "SPY." While ETFs also have expense ratios, they are much less than mutual funds. As of February 2011, the five-year returns of SPY compared to the actual S&P 500 index vary by approximately 1/10 of a percent. Unlike mutual funds, you may buy and sell the SPY at any time you wish without restriction, just like regular stock.
Leveraged Index Funds
Some ETFs return multiples of the performance of the S&P 500 index. These leveraged funds are index funds since they track the index itself. But instead of mirroring it exactly, they approximately double or even triple the index's percentage performance. For example, the ProShares Ultra S&P 500 ETF, with ticker "SSO," rises 2 percent on a day when the index itself rises 1 percent. Unlike ETFs or mutual funds, leveraged index funds are not designed as long-term investments and are most popular with day traders.