Indices

What You Need to Know About Investing in Index Funds

What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. You can buy index funds through your brokerage account or directly from an index-fund provider, such as BlackRock or Vanguard.

When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification. By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation. For example, you might put 60% of your money in stock index funds and 40% in bond index funds.

The Benefits of Index Funds
The most obvious advantage of index funds is that they have consistently beaten other types of funds in terms of total return.

One major reason is that they generally have much lower management fees than other funds because they are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index.

Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter.

“A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

What’s more, by trading in and out of securities less frequently than actively managed fund do, index funds generate less taxable income that must be passed along to their shareholders.

Index funds have still another tax advantage. Because they buy new lots of securities in the index whenever investors put money into the fund, they may have hundreds or thousands of lots to choose from when selling a particular security. That means they can sell the lots with the lowest capital gains and, therefore, the lowest tax bite.

If you’re shopping for index funds, be sure to compare their expense ratios. While index funds are usually cheaper than actively managed funds, some are cheaper than others.

The Drawbacks of Index Funds
No investment is ideal, and that includes index funds. One drawback lies in their very nature: A portfolio that rises with its index falls with its index. If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops. In contrast, with an actively managed fund, the fund manager might sense a market correction coming and adjust or even liquidate the portfolio’s positions to buffer it.

It’s easy to fuss about actively managed funds’ fees. But sometimes the expertise of a good investment manager can not only protect a portfolio, but even outperform the market. However, few managers have been able to do that consistently, year after year.

Also, diversification is a double-edged sword. It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside. The broad-based basket of stocks in an index fund may be dragged down by some underperformers, compared to a more cherry-picked portfolio in another fund.

In Summary
Index funds have several attractive pros, but also some cons to consider. Understand what an index fund is, and isn’t before investing.

Index Fund: Pros

  • Very Low Fees
  • Lower Tax Exposure
  • Passive Management Tends to Outperform Over Time
  • Broad Diversification

Index Fund: Cons

  • No Downside Protection
  • Doesn’t Take Advantage of Opportunities
  • Cannot Trim Under-performers
  • Lack of Professional Portfolio Management

Jean Folger can be contacted at PowerZoneTrading

Jean Folger has been actively involved in the financial markets for more than 10 years as a private trader, educator, and co-founder of PowerZone Trading. Jean is an award-winning author and regular contributor to industry magazines and financial news outlets. 

Her interest in technical analysis might best be explained in July 2013 interview in Technical Analysis of Stocks & Commodities magazine: “Technical analysis really clicked for me from the beginning. I am active in a lot of adventure sports like mountain biking, kite surfing, and whitewater kayaking. When I started kayaking hard rivers, I never felt comfortable just following a more experienced kayaker through a difficult rapid. I always wanted to stop above the rapid and scout it – take a look at it, watch how the water is moving, and come up with a plan based on what I saw.

Once I saw my line, I was confident I could navigate the rapid, whereas if someone else was telling me where to go, it didn’t work well for me. I had to see it myself. Trading is the same way. I felt like it was really easy to follow other people, like analysts, when making investment decisions, but I wanted to see the trade for myself. Technical analysis gave me the tools I needed to make my own decisions.” 

Jean Folger has been actively involved in the financial markets for more than 10 years as a private trader, educator, and co-founder of PowerZone Trad...