Definition of Index Funds
An index fund is a type of mutual fund or exchange-traded fund (ETF) that seeks to track the returns of a specific market index. This is achieved by investing in all or a portion of the securities within that index.
How Index Funds Work
A market index measures the performance of a group of securities that represent a specific economic market or sector. However, you cannot directly invest in the market index. If you wish to achieve approximate returns of those indices, an index fund is a practical option. When you purchase shares of an index fund, either through a discount broker or an investment company, you are indirectly investing in the securities that the fund invests in directly.
These funds buy all or a representative sample of the companies listed in the index to achieve similar returns. For example, the Dow Jones Industrial Average measures the returns of 30 large U.S. companies spanning all business sectors except transportation and utilities. The SPDR Dow Jones Industrial Average ETF Trust managed by State Street Global Advisors holds all these companies in its portfolio to simulate the performance of the Dow Jones Industrial Average. In contrast, the Dow Jones U.S. Total Stock Market Index represents all publicly traded stocks in the U.S. and holds over 3,700 stocks. The Schwab Total Stock Market Index Fund aims to replicate the performance of this index by holding a representative sample of companies in the index.
Since fund managers do not select the securities to include in their portfolios but only buy those in the index they are tracking, index funds are considered passively managed investments.
Advantages and Disadvantages of Index Funds
These funds have more advantages than disadvantages:
Advantages
There are four main reasons to buy index funds for your investment portfolio:
1. Performance matches the index: The primary reason for the existence of active equity funds is their ability to outperform their benchmark index. However, year after year, they fail to do so. In 2019, only about 40% of those funds – across all investment strategies – outperformed the main benchmark index they compare themselves against. For active U.S. equity funds, the performance was much worse, with only 29% surpassing their benchmark after fees were accounted for. Given this track record, matching index performance instead of trying to beat it seems to be the smarter investment strategy.
2. Low costs: Since index funds are much easier to manage than their active counterparts, their fees are usually lower. Low fees mean that investors have more money available to invest in their accounts. The annual cost ratios for index funds at some major investment companies are less than 0.05%. To attract customers to start investing with the company, Fidelity Investments offers four index funds that have no management fees at all.
3. Tax efficiency: Because they sell securities less frequently than their active counterparts, index funds generally have lower capital distributions. Capital gains occur when investments are sold for more than their purchase price, and the federal government taxes these gains. Reducing capital gains makes them a more tax-efficient investment option.
4. Broad diversification: An investor can gain exposure to a large segment of the market in a single index fund. Index funds often invest in hundreds or even thousands of securities, providing diversification to balance risk and reward, while active equity funds typically invest in a smaller number of securities. You can gain exposure to different types of investments by purchasing just a few index funds.
Disadvantages
There are
Two main drawbacks of index funds to consider:
1. Inexact match to index returns: Index funds cannot perfectly match the performance of their index when fees are applied. Index funds may underperform their index due to tracking errors. This problem could arise from not holding the securities that make up the index in proportion to their weight in the index.
2. Capital can lead to significant declines: Another drawback of index funds that track capital-related stock indexes is that in a market downturn, investors are more exposed to stocks that are likely to decline significantly – those that rose the most during the previous bull market.
Index Funds vs. Mutual Funds
The term “index fund” cannot be exchanged with “mutual fund.” The primary reason is that the former refers to an investment goal, while the latter pertains to the investment structure.
An index fund is a fund that aims to track a market index. Its structure can be either a mutual fund or an exchange-traded fund (ETF). In contrast, a mutual fund is a company that pools money from multiple investors and uses it to buy stocks, bonds, and other securities to build an investment portfolio. The shares of investors in a mutual fund represent a portion of those portfolios.
Unlike index funds, the investment objectives vary by mutual fund and do not necessarily track index returns. With equity funds, for instance, the goal is often to achieve above-average returns that may exceed those of the market index.
While the index mutual fund is managed passively, there are also actively managed mutual funds. These funds are likely to generate higher costs and taxes and may provide less diversification than index funds, which are characterized by their low costs and tax efficiency.
Source: https://www.thebalancemoney.com/what-are-index-funds-4842116
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