What are index funds?
Index funds are passively managed equity funds that track a certain benchmark index. The funds’ buy and sell transactions are triggered automatically based on developments in the benchmark index. They track the selected index passively, and when markets rise or fall, the values of the funds track these movements.
How do index funds work?
An index fund will only trade when its benchmark index is updated to reflect the situation in the markets. This might happen two or four times a year, for example. Index funds are also known as passively managed funds. Passively managed index funds aim to track the selected benchmark index as closely as possible. They invest in the companies tracked by the index and their portfolio managers don’t have to conduct an active market analysis or trade in the funds daily.
Are index funds suitable for your portfolio?
Cost efficiency
Cost efficiency is considered one of the pros of index funds. Managing these funds doesn’t take a lot of effort, and no active trading is required from the portfolio manager. For this reason, the management fees of index funds are usually lower than those of other funds.
Good diversification
Index funds offer investors a good diversification compared to individual equity investments. Usually, an index is composed of dozens or hundreds of companies. An example is the S&P 500 that consists of 500 largest companies in the United States. This often provides the investor a good diversification in their portfolio. There is a wide range of index funds available with different asset classes and geographical regions. Due to these features, index funds are a great fit for regular monthly saving in the long term.
When choosing an index, you should consider how the index matches your portfolio and risk tolerance. If you invest in a certain sector or a small geographical area, your portfolio may become too concentrated and be exposed to changes in the market or sector, for instance. Investors should be aware of how concentrated indices are, what sectors they want to focus on and how the performance of individual sectors affects the performance of the index.
Return of an index fund
The return of an index fund is in practice the return of the benchmark index minus the management fees. This means that if the index fund’s investments grow by about 7% a year, for instance, and the management fee is about 0.4%, the fund’s return is about 6.6% a year. For this reason, the return on an index fund, as a rule, is not higher than the return on the index the fund is tracking.
Investors should also keep in mind that usually the return on index funds is the average market return as they track a specific index. When the markets rise or fall, the values of index funds track these movements.
No portfolio manager risk
As the fund tracks its benchmark index and the portfolio allocations are based on the index, the portfolio manager doesn’t influence investment decisions. An individual portfolio manager’s decisions to sell or buy an asset do not play an important role in determining the fund’s returns.
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