Index Fund
An index fund is a form of mutual fund or exchange-traded fund (ETF) with a portfolio that tracks elements of a financial market index, for instance the S&P 500. An index mutual fund suggests an extensive market presence, low operating costs and portfolio turnover. Index funds correspond to their benchmark index, and the market’s state does not affect them. Index funds are regarded as perfect core portfolio assets for retirement accounts, for example, individual retirement accounts (IRAs), because of their safety. According to world-famous investor Warren Buffett, index funds are a kind of safe haven for money for a future life. In his opinion, the average investor should consider acquiring an index fund that provides all companies in the S&P 500 for purchase at a lower price, rather than investing in individual stocks of certain companies.
What is an Index Fund
An index fund is a portfolio, which includes stocks and bonds, having the aim of replicating the composition and results of a financial market index. An index fund is provided for almost every active financial market. The most common index funds in the US are those that track the S&P 500.
An index fund which keeps tracking a particular index will invest in the same companies that are included in that index. The point is that by reflecting the index’s profile, the fund will match its results.
An index fund may have an ETF structure. Then, each share in such an instrument is represented as a small part of the entire portfolio. This financial product is a stock portfolio managed by a professional finance team, and their goal is not to outperform the underlying index, but only to match its results. For instance, if a certain stock represents 1% of the index, the company managing index funds will tend to imitate the same composition by representing 1% of its portfolio consisting of that stock. The majority of index ETFs mirror market indexes in much the same fashion that mutual funds, that is why they can have greater liquidity and be more profitable.
Index funds keep track of portfolios of multiple stocks, whereby investors take advantage of diversification, for example, increasing the portfolio's expected return while minimizing the total risk. A drop in the price of a particular stock will not be very noticeable because it is a small component of a larger index. An index fund is considered to be a suitable investment for long-term investors. At its core, this is an inexpensive way to get a diversified portfolio passively tracking an index. An investor needs to match various index funds, to make sure that he is tracking the best index at the lowest cost that fully meets his goals.
Index funds tend to choose a passive investment strategy. The task of the fund portfolio manager is to form a portfolio whose assets replicate the securities of a specific index, rather than actively selecting stocks to invest in, i.e. stock picking, determining the time to enter the market — market timing, and developing a specific strategy for buying and selling assets.
Index fund portfolios change significantly only in the case of change of their benchmark indexes. When the fund is pursuing a weighted index, its management team can rebalance the proportion of different securities from time to time to mirror the weight of their presence in the benchmark. Weighting is a technique that balances the effect of an individual asset in an index or a portfolio.
Index Funds and actively managed funds comparison
Index funds investing is considered a method of passive investing. Actively managed mutual funds follow the strategy of active investing, which implies the instruments of securities-picking and market-timing.
The lower management expense ratio in comparison with actively managed funds is one of the clear benefits of index funds. The fund's expense ratio is made up of operating expenses, including fees to managers and different taxes.
Since index fund managers reflect indicators of a benchmark index, there is no need for analysts to help select securities. Index fund managers are less likely to trade assets, which means lower transaction fees. On the contrary, actively managed funds provide for more staff and more transactions, which automatically increase costs of running a business.
The overall fund’s efficiency directly depends on expense ratios. Actively managed funds with higher expense ratios lose out to index funds, but tend to show high total returns.
Proponents say that passive funds outperform most actively managed mutual funds. And this is true, as most mutual funds cannot beat their benchmark. However, passively managed funds don’t try to beat markets, as their strategy is to comply with the total risk and return of the market, because the market always wins. Positive results of passive management, as a rule, appear at a long distance. At shorter intervals, an active mutual fund performs better.
Summing up the above, we can highlight the positive and negative sides of index funds:
Pluses
- risk reduction via diversification
- minimal expense ratio
- high returns in the long run
- low taxation
Minuses
- dependence on market fluctuations and collapses
- inflexibility
- lack of human factor
- restricted gains
