What is an Index Fund?

Index funds differ from active funds in terms of their objectives and strategies.

Key Takeaways

• An index fund is the opposite of an active fund, and they differ from each other mainly in terms of objective and strategy.

• An index fund is the opposite of an active fund, and they differ from each other mainly in terms of objective and strategy

• An index fund's manager builds a portfolio investing in all or part of the constituent assets of a particular index to track its overall performance

• Advantages of index funds: easier to invest, market-average returns, broad diversification, lower costs, greater transparency, lower taxes, etc.

• Disadvantages of index funds: vulnerable to index swings, lack of flexibility, limited gains, tracking errors, etc.

Understanding an index fund

Many famous investors have recommended index funds. "By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals," Buffett wrote in his letter to Berkshire shareholders in 1993.

An index fund is also called "a passive fund" or "a passively managed fund," which is opposed to an actively managed fund.

Constructing an active fund requires the fund manager to pick which stocks or bonds to buy, hold, and sell in the hope of beating the market, whereas index funds have totally different objectives and strategies.

An index fund has a passive investment strategy. Its portfolio invests in all or part of the constituent stocks or bonds of a particular index based on their respective weightings, seeking to track the index's overall performance as closely as possible.

There are various indexes tracking different sectors of the market. The S&P 500 Index, The Dow Jones Industrial Average (DJIA), and The Nasdaq Composite are typical examples.

When an investor invests in an index fund, he buys a blend of investments that mimics the makeup of a market index. The investors can buy all these assets in one operation, and their returns will match that of an index.

Advantages

Index funds have many advantages.

1. An easy way to invest in stocks

It benefits those who want to invest in stocks but don't know what stocks to pick. It seems like riding an escalator. The investor only needs to choose the right escalator instead of climbing a flight of stairs by himself.

2. Provide returns at a market-average level

In the long term, returns of index funds are usually close to the market-average level returns, which may not be easy to achieve for many investors on their own, amateurs especially.

For example, from 1957 to 2020, the S&P 500 index yielded an annual average return of above 12%, outperforming many single investments.

3. Broad diversification

Since it usually invests in so many companies, an index fund tends to be less affected by market swings than a single stock, which helps balance the risks in an investor's portfolio.

4. Lower costs than active funds

Index funds are easier to handle, requiring less staff to spend fewer hours to manage them. As a result, costs are lowered.

However, keep in mind that not all index funds have lower costs. Make sure that you understand the actual costs of any fund before investing.

5. Good transparency of holdings

It’s easy to see an index’s makeup from public information, which means potential investors can also know what the corresponding index funds invest in.

6. Other advantages

Holdings of index funds don’t change frequently, so fewer taxable capital gains will be incurred from the fund, lowering the taxes for investors.

In addition, they are less affected by human factors, which may cause mistakes in decision-making.

As mentioned above, index funds are suitable for investors who want to invest in a simple, low-cost, slow-and-steady way and for financial goals like education, retirement, home purchases, and so on.

Disadvantages

Every coin has two sides. Index funds have disadvantages as well.

An index fund will follow the downward movement when the index it tracks falls.

Presented with market swings or opportunities, an index fund is less flexible than an active fund, which may cause more losses or miss potential gains.

In other words, although an index fund lowers your investment risks, it also limits the potential of your gains.

Last but not least, an index fund may not perfectly track its index. So when you invest it, keep an eye on its tracking error.

To conclude, given that index funds have both advantages and disadvantages, investors should decide whether to invest assets in index funds based on their investment objectives.

The information contained herein is for educational purposes only. Nothing discussed should be considered investment advice.