Why buying the index makes sense

Index funds are a type of mutual fund or exchange-traded fund (ETF) that are composed of stocks or bonds that seek to earn the same return as a particular index. Evaluate the pros and cons to decide if they are the right choice for you. You should know how index funds compare to actively managed funds before choosing one or more for your portfolio.

What is an index fund?

Thousands of indices track the movements of sectors and markets on a daily basis. They are used to assess the health and performance of the market. The Dow Jones Industrial Average is a broad market index consisting of 30 blue-chip stocks. The U.S. Global Jets Index tracks the global airline industry as a sector index. The index can also act as a market benchmark or a way to weight performance.

One cannot invest directly in an index, but one can invest in a fund, either through an index mutual fund or an ETF. Most index funds copy the index by holding all the securities in the index. Sometimes a fund approximates the index with a sample of the securities or with additional derivatives, such as options and futures.

Index funds are passively managed. They tend to keep what is in the index (which rarely changes) to maximise returns and minimise costs. Most mutual funds and some ETFs are actively managed. Fund managers can trade any security in their market segment as often as they want in an attempt to beat the benchmark.

Pros and cons of index funds

Pro

• Reliable performance
• Low costs
• Transparency
• Easy diversification

Cons

• Lack of flexibility
• Tracking error (for physically replicating ETFs)
• Management differences

The pros of index funds

You should get the same return as the index, minus fund management costs, if you invest here. Index funds have better returns than actively managed funds in most cases.

The portfolio of an index fund rarely changes. This stability translates into lower trading costs and fees. The operational costs of the fund are reduced, because there is no need to hire portfolio managers or stock researchers, or to pay the fees that result from constant trading. Active fund costs are about 1.3%, or $1.30 for every $100 in the fund.2

Many index funds simply hold what is in the index, so you can always see the fund’s holdings. This allows you to better judge the risk of an index fund based on these holdings. An index fund that tracks the volatile oil and gas sector can be much riskier than a bond index fund.

You can buy slices of hundreds or thousands of companies at once, rather than individual stocks, as you try to build your portfolio. This diversification reduces risk. If one stock or bond is down for a day or a year, another is most likely up.

Cons of index funds

The fund typically holds the same securities, regardless of market direction, because its purpose is to follow the index. The fund manager cannot sell securities that are underperforming, especially during a large market decline.

This lack of flexibility means that index funds do not have the opportunity to outperform the benchmark. You are guaranteed the return of the index when the market (or the sector) recovers, but you are also guaranteed the loss of the index when the market falls.

The difference between the return of an index fund and the performance of its benchmark index reflects the costs of managing a portfolio. This is called the tracking error. Always choose the one with a lower tracking error when comparing index funds that follow the same index.

Indexes are not objective. They are created by companies that determine the composition of an index. The decision-making process is not strongly regulated. It is not always transparent and can be influenced by general management tactics. Sometimes index funds and the index have the same managers, which can create a conflict.

How to choose an index fund?

You should weigh some important factors before buying an index fund. First, how much risk are you willing to take for return? What are the risks associated with the fund you are looking for? Does its strategy fit your investment objectives?

How much will you pay to buy, own and sell the fund? Compare the transaction costs of funds covering the same sector. And last but not least, when will you need the money?

An investor should read all available information about the fund, especially its prospectus.

Are index funds good investments for you?

Index funds, ETFs and mutual funds have consistently outperformed actively managed funds. They can be good investments, but they are not all the same, so always do your research. You may be able to find your answers on your own or you may need the help of an advisor.

How do I invest in index funds?

You will need a brokerage or retirement account to invest directly in index funds. Once you have a way to invest, you can place a purchase order for an ETF or mutual fund that follows your target index.

How many index funds should I own?

The number of index funds you own should depend on how diversified those indices are. If you invest in well-diversified funds, you may only need one or two. If you invest in targeted funds that follow specific sectors, then you should own many funds to build a broad and diversified portfolio. You could also put most of your money in a well-diversified fund and save a small amount to try investing in different targeted sectors.

How much money do you need to invest in index funds?

You can start investing in index funds with just a few dollars. However, it is not wise to invest more than you can afford to lose, especially if you have no emergency savings.

Source of this article: www.thebalance.com