What Is an Index Fund?
An index fund is just a type of mutual fund or ETF (exchange-traded-fund). An index fund serves to track the performance of a specific market benchmark or “index” like the S&P 500 as closely as possible. While the S&P 500 is probably the most popular for mutual funds and ETFs, there are other indexes out there that are used for other specific markets. Index funds can be purchased through online brokers or from an index-fund provider.
An index fund is something that investors use to generate passive income. As opposed to hand picking individual stocks or bonds, you purchase a fund that gives you a diverse selection of securities in one investment. There are some funds that can even diversify your portfolio to the point where you have exposure to thousands of different securities within the same fund. By diversifying your portfolio with index funds, you also limit the risk. The old adage “all your eggs in one basket” springs to mind, as you are giving yourself many different eggs to work with in this example.
How are index funds advantageous?
There are a number of reasons why index funds can work to your advantage. Let’s take a brief look at how indeed funds work for you.
The overall managing costs of an index fund are low. This is because you aren’t doing any active trading or picking any stocks out. You don’t need a team of researchers analysing securities or a manager who is actively trading which means your overall trading fees are nominal at best.
Broader exposure to the market
By investing in an index fund, the investor is exposed to a much broader range of stocks and markets. This can aid the investor in cashing in on returns of the larger market segment through a single index.
As these index funds are being passively managed, there are far fewer trades being placed by the manager throughout the course of the financial year. With fewer trades being executed, you are not having to realize as many capital gains which means far less tax.
Easier to manage
All a fund manager has to do is regularly rebalance the portfolio of the index fund. Aside from that, the index fund is running itself, as it is not concerned with how the stocks and markets are performing.
No emotion investing
The fund manager is provided with a mandate and from there, the fund is completely automated. This means that you cut out all biased or emotional trading from the equation.
What are the limitations of index funds?
While index funds provide investors with stability, diversity and passive income, there are still one or two drawbacks of this kind of investment strategy.
No downside protection
When you invest in an index like the S&P 500, you will benefit when the index hits a high but you also have no protection when the index is in a slump and continuing on a downslope. The floor on an index can be severe for your fund.
No active management
As your index fund is being run passively, there is no possibility for the manager to act on advantageous knowledge when a stock is overvalued or undervalued. This means you can’t take advantage of a stock price at all, you are simply left to the whims of the passivity of the index fund.
Limited strategy changes
The best investors will implement trading strategies for certain situations or in response to certain market movements. Yes, an index fund gives you ample diversification for your portfolio but you could achieve a steady level of diversity by investing in 40 different stocks yourself. The catch with the index fund is weighing up the passivity (limited overall risk for the most part) versus a more active role in your own trades that could result in bigger returns (but greater risk).
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