How to Choose an Index Fund

Security-market indexes allow investors to compute total returns and risk for an aggregate market or some components of a market over a specified period of time. The computed return of the aggregate market is then used as a benchmark to compare the performance of individual portfolios. This makes sense because investors should constantly outperform the market. According to a basic assumption of portfolio performance evaluation, investors should be able to experience a risk-adjusted rate of return comparable to the market by selecting a large number of stocks of bonds from the total market. Benchmarking an aggregate stock market index does exactly that.

Index funds are passively managed mutual funds that buy stocks and hold them in a portfolio that approximates the index. The most commonly trailed index is the S&P 500, consisting of 500 large companies selected by Standard & Poor's, while the best recognized index fund is the Vanguard 500 from The Vanguard Group, which tracks the S&P 500.

To choose an index fund, investors should primarily know which index the fund follows in order to be able to handle the risk and expected. Not all index funds have the same risk-return relationship. Moreover, the performance of an index fund does not exactly match that of the index because of management fees.

The increased variety of index funds over the last ten years has also increased the flexibility in constructing a well-balanced portfolio made up entirely of index funds. Therefore, it becomes essential for investors to be aware of their numerous options.

Considering the cost and the tax effects is another factor that needs to be examined. A common assumption about indexing is that all index funds are cheap because they do not demand the resources of active management. Yet, some index funds charge surprisingly high annual expenses. Moreover, another common belief is that all index funds are tax-efficient. Yet, it depends on the position that the index funds sell. Small positions do not obtain considerable taxable gains.

Index funds offer diversification and lower fees than actively managed funds. Investors receive capital growth and a dividend income return similar to the market as a whole. Thus, index funds are the best solution for investors who believe that stocks outperform other investment classes and want to allocate their share investments without worrying about potential managerial flaws such as those that occur to actively managed funds.

Conclusively, index funds are the best solution, especially for investors, who prefer long-term growth without having to pay much attention.