An Introduction to Index Funds
Yimin Huang | August 2nd, 2022
Source: Scripbox
Introduction
An index fund is a mutual fund or exchange-traded fund (ETF) with a portfolio designed to track and match the composition of a market index, like the Standard & Poor’s 500 (S&P 500) Index, the Russell 2000 Index, and the Wilshire 5000 Total Market Index.
Index funds utilize a form of passive fund management whereby the portfolio composition mirrors that of the securities of a particular index. This is opposed to active fund management which involves a fund manager actively picking stocks and strategizing when to trade them. By matching the risk and profile of the index, the fund will match the return of the market as well. Because of this, index funds are generally one of the easier and low-risk ways a beginner retail investor can get started. They are also generally considered ideal core portfolio holdings for retirement accounts.
Because of its passive investment strategy, index funds typically have lower expenses and fees than actively managed funds as their operating expenses, including payments to fund managers and for the services of research analysts, taxes, and accounting fees, are lower. Holdings are also traded less frequently, incurring fewer transaction fees.
Having considered the key characteristics of an index fund, below is a list of advantages and disadvantages of index funds at a glance.
20201104-123052.jpg)
Source: UTI Mutual Fund
Pros of investing in an index fund
1. Greater diversification and hence lower risk:
Index funds track a market index, matching its composition with a highly diversified portfolio that reduces the risks of an investor suffering significant losses if one or two shares perform below expectations.
2. Strong long-term returns:
Passive funds have historically been successful in outperforming many actively managed funds with steady performances. According to the SPIVA Scorecard report of the S&P Dow Jones Indices, during the five-year period ending Dec. 31, 2020, the majority of large-cap U.S. funds (75%) realized a return that was less than that of the S&P 500.
Source: Capital.com
Cons of investing in an index fund
1. Limited returns in the short term
Because of its investment strategy to match the market returns, index funds are unable to outperform the market and achieve a large gain, especially within shorter time periods. The SPIVA Scorecard shows that in the span of a year, more than 86% of midcap mutual funds beat their S&P MidCap 400 Growth Index benchmark in the course of a year.
2. Limited loss protection
Since the index funds track the markets in both good times and bad, in a bullish or bearish market. When the market plunges, like during the coronavirus crisis when the S&P 500 fell 30% over the span of 22 trading days, its fastest decline ever.
Now that we’ve had a broad overview of the ideal and the not-so-ideal aspects of an index fund, let’s dive deeper into the forms that an index fund can take. In the beginning, we mentioned that an index fund is a mutual fund or ETF. So what does each of these terms mean?
Source: The Financial Express
Mutual funds
A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities. They are operated by professional fund managers who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. Mutual funds give small or individual investors access to diversified, professionally managed portfolios, which are structured and maintained to match the investment objectives stated in its prospectus.
Source: Investor Junkie
Exchange-traded funds (ETFs)
ETFs on the other hand refers to a basket of securities that can be traded on an exchange just like a stock. It operates similarly to a mutual fund, though there are some differences.
Source: Nairametrics
What is the difference between the two?
Unlike mutual funds, ETFs are traded on a stock exchange the same way that a regular stock can at any point during the trading day and at the price at that instant based on market conditions. As the ETF is purchased and sold, its share prices fluctuate, in contrast with mutual funds which only trade once a day after the market closes. The purchase of a mutual fund is executed at the net asset value of the fund, which represents the intrinsic value of each share of the fund.
ETFs also typically carry lower fees than the equivalent mutual fund as buyers and sellers are trading directly with each other, and the managers have less to do except adjusting the supply of shares to align the price of the ETF according to the net asset value of the index. Some ETFs can be purchased commission-free and do not charge marketing fees, compared to mutual funds which typically charge administrative and marketing fees.
ETFs also enjoy tax advantages from mutual funds. Investors in ETFs and mutual funds are taxed according to the capital gains and losses incurred within the portfolios. The creation and redemption mechanism of ETFs work such that when an investor sells an ETF, it trades like a stock with no capital gains transaction to be reported at tax time.
Conclusion
Index funds are just one of the many types of investments and financial instruments out there. Regardless, Warren Buffett himself has recommended index funds for the average investor rather than picking out individual stocks for investment. The popularity of index funds is reflected in the $400 billion invested into index funds across all asset classes, according to Morningstar Research.