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Index funds are mutual funds or exchange-traded funds that have a portfolio of stocks to mimic several indexes. They are made to match the investment results of a specific market index. They can include stocks or bonds in their portfolio. These mutual funds also differ in the tactics; they are employed to achieve returns in line with their chosen index. Index funds are different from non-index funds, which help improve market returns rather than align with them.
Index funds promise ownership of a wide range of stocks, greater diversification, and lower risk, all at a low price. Hence, according to investors, index funds are more excellent investments as compared to individual stocks. The index is a relatively new and low-risk way to invest in stocks. It comprises hundreds of the largest, globally diversified companies across every industry. Of course, if something significant happens, the whole market can oscillate dramatically.
Few easy steps to invest in index funds
It’s easy to spend in an index fund, but you should know what you’re investing in and not just buying random funds that you are generally unaware of!
1. Select an index fund to invest in:
You should begin by exploring what you want to invest in! An S&P 500 index fund is the most widely accepted index fund, as it also exists for different countries, industries, and even investment styles. Hence, you should understand where you want to invest and why this investment might be an excellent opportunity. Consider the geographical location of your assets. A broad index like S&P 500 owns American companies, while other index funds focus on narrower places. The type of industry you are investing like tech or pharma companies, can be a deciding factor while choosing investments as some funds avoid specific sectors and specialize in others.
You should understand the market opportunity does the chosen index fund presents. Several funds want high-growth stocks, while others want to invest in high-yield stocks.
Always carefully examine the fund you are investing in so that you know what you actually own. At times the labels on index funds can be deceptive. However, to see exactly what’s in the fund, you can check the index’s holdings.
2. Choose which index fund to purchase:
Once you’ve zeroed down on a fund you want, you can find other factors that make it a good fit for you. The fund’s expenses are a huge factor that can cost you thousands of dollars over time. It is always wise to compare the expenditure of each fund you’re considering. Mutual funds are less tax-efficient than ETFs, as they do not pay a taxable capital gains distribution, like other mutual funds at the end of the year. Several mutual funds have a minimum investment amount for the initial purchase. However, ETFs don’t have those rules.
3. Buy the index fund
Now comes the easiest part of buying the fund. You can purchase through a broker or directly from the mutual fund company. However, buying through a broker is much easier.
Here are the advantages and disadvantages of investing in index funds:
1. They are comparatively low risk and provide steady growth
The advantage of index funds is that it is a pretty low-risk option for investing in bonds and stocks. It is specifically designed for stable and long-term growth. It is inherently diversified and represents several sectors within an index that protect us against deep losses. They often do better than the majority of non-index funds that struggle to beat the market.
2. They offer low fees
Index funds present lower costs for investors than non-index funds, as they are passively managed funds. Even when a non-index fund performs better than the index funds, it must perform well by a certain margin for generating returns that beat the fees that it charges. The funds that are actively managed have many more transactions than index funds. Hence they have higher costs.
3. They allow diversification
You are getting the benefit of diversification that the index offers, limiting your risks since investing in an index. A win-win situation for all!
4. It helps in tracking performance
You have a benchmark against which you can assess your fund’s performance since you invest in a specific index. It is shown in the tracking error of the fund.
1. They lack flexibility
Index funds enjoy less flexibility than managed funds because managers tend to follow policies that require them to perform in lockstep with an index. Decisions of investment in index funds should be made in the constraints of matching index returns.
2. It doesn’t provide large gains
Unlike index funds, managed funds have the potential of outpacing the market. So, it’s like you are surrendering the possibility of a massive boost if you invest in an index fund. The top-performing non-index funds might change from one year to another. That way, under-performing years cancel out the over-performing ones, and index funds’ performance remains steady.
3. It has the risk of a downside
While actively managed funds have managers who predict and take corrective steps during market falls, index funds simply mimic the fall. No one can guarantee that the manager will be able to handle the fall effectively.
4. Index funds are open to the risk of tracking error.
There is an extent to which the index fund tracks the index. Tracking errors may occur due to changes in the index, liquidity provisions, and more. Index funds lose out of the fund manager’s proficiency and structured investment approach that an active fund manager brings.
Index funds have generated good returns over a long time, baring the Covid-19 pandemic. They overcome the human biases and give massive discretion to a fund manager, which can be a concern of several investors. Index fund removes the fund manager’s biases, conditioning, and past experiences from the equation. However, somebody who doesn’t have the skill of selecting good mutual funds or direct stocks should go with index funds.