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Introduction to Index Fund Investing

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A mutual fund index is an investment portfolio that matches a target “index” or benchmark. Common indices include Standard and Poor’s (S&P) 500, Russell 2000, Wilshire 5000, etc. This investment vehicle is quite possibly the most popular mutual fund option available to investors from individual to institutional investors.

The index is a passively managed fund, meaning that the fund is not actively managed by a person making decisions. The simplicity of replicating a market like the Russell 2000 requires little decision making to pick stocks. In other words, the Russell 2000 index fund would mirror the same 2000 stocks in the Russell 2000.

Although it’s commonly preferred by small investors, index funds appeal to a wide array of investors because of their advantages. Most notably, an index such as the S&P 500 has historically out-performed other actively managed portfolios. How’s a non-managed fund able to beat wall street professionals? The fund actually has lower expense ratios, which means that the real returns become magnified over the long run. On average, the expense ratio is roughly 1.9% for most non-indexed funds. However, with an index, you’ll find the ratio close to 0.1% expenses. This is attributed to the low maintenance involved in managing the portfolio. It takes less time and resources to manage this type of fund.

Moreover, from 1975 to 2000, only 1 out of 5 professional mutual fund managers did better than their comparative index. A fund manager with a wealth of knowledge in stock and bond investments actually performed worse than the market. So the saying goes, “If you can’t beat ’em, join ’em”.

There are also tax advantages for investors of index funds. Since they simply replicate a benchmark, there are fewer transactions, or fewer turn overs. The costs to sell or buy stocks, bonds or cash reserves are far less than an actively managed portfolio that sells investments much more frequently. This means the investor reports fewer capital gains due to stock sales. Ultimately, lower turnover means fewer costs to the investor.

Diversification is another key advantage. If you examine an index such as the Wilshire 5000, you’ll find stocks that fall into so many different categories. As one can examine, the index holds approximately 5000 different stocks that range from small capitalization stocks to giants like General Electric. A fund that holds, say, 100 stocks may be exposed to much more volatility than this Wilshire 5000. As one can see, this fund would provide much more stability.

Despite the many advantages, index funds are not exactly perfect. The biggest criticism is that they perform just like the market. If Dow Jones goes up, then the S&P 500 Index goes up. However, in a dramatic downturn in the market, the same S&P 500 index will go down dramatically. Ultimately, the fund has no chance of beating the stock market; it’s simply follows the market movements.

Index funds are a good way for investors to hold and let go of their investments for the long run. They are portfolios with a wide range of stocks or other investment vehicles. They provide, in most cases, diversification for individuals seeking to make their portfolio safer and less volatile. Although index funds do not provide out-performing gains, they do allow an investor to sit back and let the fund take care itself for the long term.

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