Do you know someone who wants to start investing, has the resources for it, but doesn’t have the time to understand how it works? Maybe it is time for you to introduce them to index funds. Previously, we have talked about mutual funds, an investment fund that has 2 types: active and passive investing. In this article, we are going to talk about the passive investment type of mutual funds which is the index funds.
What is an Index Fund?
An index fund is a type of mutual fund that aims to replicate the performance of a particular market index. The term “indexing” is a passive investment strategy that aims to achieve the same risk and return of an index by investing in index funds. Its primary advantage over active investing is the lower management expense ratio of an index fund. As proven by previous years, index funds have been successful in outperforming most actively managed mutual funds.
Index funds work this way: When an investor purchases a share of an index fund, it means he is purchasing a share of a portfolio that contains the securities in the underlying index. The index fund has the same securities in an equal proportion as that of the actual index. When the index’s value decreases, the index fund’s shares decreases as well, and vice versa.
The returns of an index fund usually don’t exactly match the actual index’s performance. This is because index funds charge management fees, which is deducted from its returns. The degree to which the fund and the actual index differ is the tracking error.
Advantages of Index Funds
Diversification – Each index fund represents an underlying basket of securities to replicate the actual index it follows. It is a popular way to participate in the market with a diversified portfolio managed by a professional. Diversification also makes index funds less exposed to downside risks compared to investing in individual securities.
Read more about portfolio diversification.
Simplicity – Managing an index fund requires diligence to one trading style. Unlike actively managed funds which may undergo several changes to maximize returns. The investment objectives of index funds are also easy to understand. Managing an index fund usually only requires rebalancing every six months to a year.
Low cost – Buying and selling shares of an index fund costs less than separately buying and selling of individual stocks. Index funds also have a relatively lower expense ratio compared to actively managed funds. Thus, making it more affordable to invest in them.
Liquidity – Index funds are traded just like normal stocks, in fact, they even have their own corresponding ticker symbols and are traded daily on all major exchanges. Unlike other mutual funds which can only be withdrawn at the end of a trading day, index funds can be bought and sold easily at any time of the day.
Returns – Studies have proven that over the long term, index funds outperform actively managed portfolios. One of the best techniques to reducing risks in a turbulent market is by diversifying. Although actively managed mutual funds are typically well diversified, research has shown that they usually don’t perform well over time. The key to the performance of index stocks is because index fund managers don’t try to beat the market like how others do. Instead, they try to be the market in order to succeed.
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