The index fund is basically a type of mutual fund that works closely with the market index (stock market index). The index fund is a portfolio of stocks or bonds which mimics the structure as well as the performance of a financial market index.
A market index is the measure of the performance of stock or bonds, which helps you to evaluate market performance more easily. Broad Market Index Funds, Equity Index Funds, Bond Index Funds are some examples of index funds.
In simpler words, it is a type of financial channel that collects money from investors to invest in stocks, bonds, or any money market assets and that pool of money is used to purchase a portfolio of assets.
Like mutual funds index funds are also operated by professional money managers. Index fund allows investors to have access to professionally maintained portfolios of equities, bonds, and other securities.
Advantages and Disadvantages of Index Funds
The index fund is lightweight hence has lower expenses and costs. Index funds basically follow a passive investment strategy. Though index fund lacks some benefits of actively managed funds; however, index funds are less expensive and usually have better returns over the long term. Index funds generally aim to maximize returns over the long run by not doing frequent sell or purchase securities.
The portfolio of the index fund matches components of the financial market index including the risk and return of the market hence provides broader market exposure. In this way index funds simplify the investing process. Investors get interests, capital gain on a regular basis which is a great plus. Let’s go through the pros and cons of index funds:
Advantages of Index Funds
One major advantage of index funds over actively managed funds is the cost. The expense ratios of an index fund usually range form range from 0.10% to 0.70%(for large US-based companies).
One of the natural ways to get a higher investment return is to pay fewer fees in investing. Index funds have a lower cost because of their passive management. One main reason for the higher fees of actively managed funds that are they tend to have many more transactions than index funds and have more employees.
Investing in index funds may be able to save costs. The low cost of the index fund is because of its passive management as they do not spend time and money on market research and selling or purchasing shares.
An index fund provides you with a diversified portfolio of stocks, which means you are investing in a bunch of securities at the same time. It buys the securities that make up the whole index that means buy shares from every company listed on the index.
Index funds usually invest in hundreds of securities while actively managed funds to invest in less than 50 securities. So when you invest in an index fund, you automatically have access to the investment portfolio made up of a bunch of securities. If the fund has a higher amount of holdings, it automatically has fewer risks.
3. Long-term Growth Potential
Warren Buffett, a well-renowned investor, has suggested index funds as the safest place for savings for the later years of life. Index funds are often defined as the funds for the long run.
To achieve maximum profit (return), index funds do not sell or purchases securities more often. If you invest in an index fund, you are guaranteed to get a better return in long run. The lower cost of the fund makes a huge difference in the long haul.
4. Low Risk
Another key benefit of index funds is that they have less market risk compared to their counterparts. Since index funds are diversified, representing many different securities within the portfolio, which helps lessen the risk that comes with investing in a single security/stock.
The fund with wide diversification has lower market risk compared to the fund with limited diversification. Also, the return of the index fund is better than the actively managed funds. This is one of the reasons why index funds are popular among investors.
5. Better Returns
The fewer expenses and broad diversification of index funds made them successful in outperforming most actively managed mutual funds. In the last five years, the S&P 500 generated a better return than 80% of the large-cap funds. Standard & Poor’s 500 Index(S&P 500) has an average return of 10% per year.
The return of the index funds is usually better than the actively managed funds and have fewer market risks as well. The low cost and high returns of the index funds make them an excellent choice for investors.
6. Simple and Straightforward
The investment objective of the index funds is easy to grasp, hence helps to understand the investment strategy more thoroughly. An investor must know the target index of the fund he is investing in.
Index funds are transparent in their investment objectives. Also, there occurs no style drift in index funds as it occurs in actively managed funds where those funds sometimes go outside their prescribed style during market fluctuation.
Disadvantages of Index Funds
1. Less flexibility
Since index funds as passively managed, during market fluctuations, the fund manager cannot sell or purchase the securities. This is because index fund managers must follow some policies and strategies that prevent them from doing so. The fund manager in an actively managed fund has more flexibility to find better-performing options in times of market fluctuations.
2. Not for Short Term
The index funds are designed for the long run and if you are expecting huge returns within a year or two, then try investing in other funds. There’s little chance for achieving big short-term gains with index funds as it is long haul based. Those investors seeking significant short-term gains should not expect much from index funds.
3. Underperformance and Vulnerability
The index fund may underperform its index because of fees and expenses. Underperformance has a direct effect on the investments, which in turn creates risks.
As index funds are functions of the market index, with the decline of the benchmark value, the value of the index fund will also drop. Also, index funds don’t offer much flexibility, so management cannot do anything about it.
4. Tracking Error
It is obvious that the business market is unpredictable, and it is constantly changing. As index funds strive to match market returns, both under- and over-performance compared to the market is regarded as a tracking error. For example, an inadequate index fund may produce a positive tracking error in a falling market.
It is very crucial to read and understand the available information regarding the fund before investing in it. Every investment has some risks associated with it; however, index funds have less risk, are cost-effective than other funds, and offer broad diversification.
These advantages make the index fund a better choice for investors. If you want to invest in index funds, consult with a financial advisor, which will help you choose the best index fund that matches your investing goal.
References(Last Updated On: April 6, 2021)