How y’all? Today I am going to discuss with you a simple, but important question that I got asked many times. The question is equally important for an experienced or a newbie investor. So let us look examine this question from different facets.
But let us start with first thing first. What is an index fund?
Simply said, an Index fund is a replication of a market index. The market index can be S&P 500, Dow Jones Industrial Average, Nasdaq Composite, Nasdaq 100, Russell 1000, 2000 or 3000 or any of the other lesser known indexes. The investor is expected to own all stocks in approximately in the same proportions that they make up in the index. Some indexes are created based on specific sectors, geographical areas and stock exchanges. So Index funds are equivalent of a mutual fund tied to stock mix of an Index. The funds that track these indexes hold the same investments in almost the same proportions as the index itself. This results in an automatic increase in the value of the fund when as the index goes up.
By virtue of being tied to an Index, index funds do not require extensive time and resources from fund managers to create and manage these funds. That is the reason index funds are are known for their low or minimal fees compared to the actively managed mutual funds. Just to give an idea, the average cost also known as expense ratio is between 0.05%-0.07% with some going as low as 0.02%, while actively managed funds charge between 1.0% to 2.0% per year. We will not get into the full mathematics here, but you can clearly see how much money you can save in a 20 or 30 years by investing your money in a good index fund as compared to an actively managed fund.
Apart from the low cost advantage, here are additional key benefits of investing in index funds:
- Save the time and effort of having to research investments and manage a portfolio yourself.
- Broad Diversification
- Save the transnational costs lost buying selling individual stocks and payments to a financial adviser
- Index funds are tax efficient as there is not much buying and selling of securities causing extensive short and long-term capital gains as compared to mutual funds
- Less volatile and low risk as compared individual stocks
- Individual stocks may rise and fall, but market rise in value over time so does the funds directly linked with the market index
Just to give you an inside scoop, Vanguard founder, Jack Bogle invented the Index Funds in 1975, precisely on December 31st. So, it is a time tested investment vehicle. For the investors it maters
Index funds provide individual investors a solid foundation to build a diversified portfolio with solid returns in the long term with lower risk as compared to mutual funds or individual stocks without the need of actively managing the portfolio by the investor or a financial adviser.
Before you decide to take a plunge into investing in an index fund, just one word of caution. Index funds don’t try to beat the market, or earn higher returns compared with market averages. Index funds rather try to mirror the performance of the index as a whole. So, if you are good at picking the stocks that can yield better returns than the market, index funds may limit your returns. But research shows that despite having all the education and resources at their disposal, even only a handful of active fund managers outperform the market. So, tread that path with caution!!
If would like to invest in index funds, here is list of our top picks for best brokers for mutual funds.