Index Funds
By Wittmann Goh
Adapted by Nicolette Lamanna
What are Index Funds?
“An index fund is a pooled investment vehicle that passively seeks to replicate the returns of some market index.”
-Investopedia
Pooled investment vehicle – invests into assets using funds from many investors, rather than just your own
Replicate returns of some market index – gains (and loses) mirror the performance of a group of companies tracked by the particular index
Why Index Funds?
Investors cannot directly buy into a stock index. Index funds exist to give investors a way to invest in the performance of the assets tracked by an index!
How do Index Funds work?
“Passive Fund Management”
Index funds managers rebalance the portfolio (group of investments) of the index funds to match the composition of the index
For example, if the index is made up of 50% Tesla stock and 50% Apple, the manager will ensure your index fund has ~50% of its value invested in Tesla and ~50% in Apple
Buy into the index fund and you’ll own a fraction of all the stocks the index fund holds!
Pros and Cons: Are index funds the right choice for me?
Advantages
Diversification
Index funds naturally hold stocks in a large number of different companies – usually hundreds or thousands!
Buying into index funds gives you exposure to all the stocks held by the index fund. This allows you to achieve diversification easily which helps to reduce risk, since several stocks across different are less likely to lose value than any single stock!
Reliable Performance
Since index funds are designed to track the performance of stock indices, investors typically get returns that mirror the growth of the underlying index.
Lower Costs
Since index funds are passively managed, fees are much lower than buying into an “actively managed” fund (where a team of managers actively try to outperform the market).
Disadvantages
Tracking Error
While the goal of index funds is to track an index, sometimes they aren’t able to do so with complete accuracy. This is called tracking error.
Tracking error may cause the returns from the index fund to deviate from the performance of the index, leading to lower-than-expected returns.
Rarely Outperforms Index
Since the fund aims to mirror the index, it rarely gives better returns than the stock market. Also, when the market falls, so does the index fund.
Lack of Flexibility
When you buy into an index fund, you buy into all the stocks that the index fund tracks – you don’t get to choose. This may be disadvantageous to investors who want more control over their funds.
Should I Invest in Index Funds?
While the answer isn’t yes for everyone, definitely consider it!
Low entry costs
Relatively low risk due to built-in diversification
Minimal expertise is required to get started
How to Choose an Index Fund: Decision Factors
1. Expense Ratios
This is the ratio of the operating expenses of the fund over the value of the assets held by the fund:
The rule of thumb is: The higher the expense ratio, the less you earn – so look for low expense ratios!
Even a couple fractions of a percentage point can have significant bearing of how much you get out of the fund over the long-run.
2. Fees
Some funds might charge front-end loads (fees for purchasing an investment) or back-end loads (fees for selling off investments).
Other types of fees include 12b-1 fees, which are similar to an annual fee.
Although an index fund may have a low expense ratio, watch out for the other fees involved! It can tip the balance when comparing different index funds.
3. Advanced Considerations
These have an indirect impact on your return-on-investment but may also influence your decision!
Tracking errors – how well does the index funds actually mimic the index?
Underlying index – do you just want to invest in the overall top-performing companies, like with an S&P 500 fund? Or is there a specific sector you are interested in? Perhaps you are feeling particularly hopeful about the tech sector. Then look for index funds tracking tech indices.
Risk Level – even though index funds all seek to replicate an index, they do so in different ways. Aggressive funds hold a more growth-oriented portfolio, albeit with higher risk. Choose an index fund with a risk level you are mentally and financially prepared for.
“A low-cost index fund is the most sensible equity investment for the great majority of investors.”
-Warren Buffett