Final answer:
Index funds are mutual funds that own a tiny share of every firm in the market index they track, offering broad market exposure and mirroring the index's performance. They adjust their holdings based on index changes using automated rules, providing investors with a passive investment strategy.
Step-by-step explanation:
Index funds aim to replicate the performance of a stock market index by holding a portfolio that mirrors the index. They typically own a fraction of every stock within the index they track, creating a form of diversification. The index fund adjusts its holdings to stay aligned with the index, primarily through automated rules or formulas rather than active management. When the underlying index rebalances or when the holdings in the index change, the fund buys or sells stocks according to those changes, which may be due to stock splits, company mergers, or re-evaluations of company market capitalizations.
This type of fund offers investors broad market exposure and low portfolio turnover. Since their goal is to match the index, not beat it, they typically have lower management fees than actively managed funds. Index funds are preferred by investors who are looking for a low-cost, passive investment strategy to achieve a return rate close to the market average.