Guide to Index Funds

An Index fund is a collective investment scheme that mirrors movements of an Index of a specific financial market. An ideal index fund will hold the same stocks that comprise the index and in the same percentage. But in reality Index funds do not buy every underlying security in a given index; instead, they buy a selection of securities whose performance closely tracks that of the index as a whole. Index Funds are of two types: Exchange Traded Funds (ETFs) and Index Mutual Funds. ETFs are essentially index funds that are traded on a stock exchange and an index mutual fund has to be purchased either through a broker or directly from the company that manages it.

There are two types of investing, active and passive. Active investment usually aims to deliver returns that are greater than some benchmark index. Actively managed mutual funds hence will deliver more returns and involve more research and cost. Passive investment is investing in a fund whose objective is to match the performance of an underlying market, or part of a market, as measured by some index. Index funds are all passively managed and hence deliver lower returns and have lower costs.

Different types of index funds follow different indexes like Broad Market Indexes, Large Cap Stock Indexes, Mid Cap Stock Indexes and Small Cap Stock Indexes. There are also Bond index funds which track the Bond index.

It is advisable that the investor considers the following advantages and disadvantages before investing with index funds:

Advantages:

1. Low cost:

Index funds do not require much research and do not need to be actively watched. Stocks do not jump in and out of an index on a daily basis. Hence there is no need to have highly paid research teams and stock pickers as in the case of diversified mutual funds.

2. Simplicity:

The goals of Index funds are easier to understand. There is also no need to understand the investment strategy of an index fund. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly.

3. Low turnover:

There is no continuous churning of shares as in the case of mutual funds. Continuous buying and selling may result in capital gains which are taxable. The fund company might charge the investor in such cases.

Disadvantages:

1. Cannot outperform the market:

Index funds can never outperform the markets unlike Diversified mutual funds. Hence the best index funds will always give lower returns as compared to mutual funds. When the stock markets are doing well mutual funds always give better returns than the index funds.

2. Not immune to market bubbles:

Index funds might be less risky but they ultimately depend on the stock markets. If the market bubble burst, there will be an impact on the index stocks and ultimately on the index funds as well.

3. No diversification:

Since Index funds invest only on a particular section of the market they cannot diversify. So if a particular index is not doing well, the fund may perform badly as well.

It can be safely concluded that index funds don't make the grade as standalone investment avenues. Instead, investors' interests are likely to be better served by holding a portfolio comprised of well-managed diversified equity funds with proven track records across parameters and time frames. Index funds can be retained as a safer option.