How to Use Index Funds as Low-cost Options for Investors

Index funds are designed to imitate the performance of benchmark market portfolios and replicate the movements of an index of a specific financial market. To achieve that, the fund purchases all the securities in the index and buys or sells investments according to the index changes aiming to always keep in line with the underlying index.

One of the main advantages of index funds for investors is that they are passively managed and as such, they incur lower-than-average management fees costs and lower expense ratios than actively managed funds. Because an index composition does not change frequently, fund managers have to make fewer trades when dealing with index funds and therefore fees and taxes are lower. On the contrary, fund managers, who deal with actively managed funds, have to follow the track of the index on a regular basis in order to anticipate any changes in its composition. Consequently, fees and taxes are higher.

Index funds do not incur expenses related to the stock selection. Typically, index funds use sampling and mirroring models to decide the appropriate timing to buy, hold or sell individual securities and be in agreement with the target index. However, this does not guarantee that passive management is always effective, because sampling and mirroring models are, by default, not 100 percent accurate and this justifies the occurrence of tracking errors.

Index funds offer to investors a high level of diversification at a relative low cost. If investors would invest directly in stocks using the same portfolio allocation, they would probably incur significantly higher costs. Moreover, index funds are always fully invested to the particular index, which means that portfolio returns are higher during market upturns and lower during market downturns. However, investors should be aware that indexing is quite a risky investment strategy during economic downturns. Instead, an actively managed fund would consider risk as an opportunity and would outperform the index.

To choose properly an index fund, investors should know which index the fund mirrors and what is the risk associated to the index. The risk/return relationship is not the same in all index funds and therefore, investors should choose an index fund that really reflects the risk that they are willing to undertake.

Considering the tax effects associated to an index fund is another important consideration. A common assumption about index funds is that they are cheap because of passive management. However, some index funds incur high annual expenses and do not obtain considerable taxable gains as their gains depend on the position they sell.

The most widely used index funds track the Standard & Poor's (S&P 500) index, the Russell 2000 that tracks small companies, the MSCI EAFE that tracks the performance of foreign stocks in Europe, Australasia, and the Far East, the DJ Wilshire 5000 that measures the performance of all U.S. equity securities, and the Lehman Aggregate Bond Index that that tracks the performance of bond market.

Conclusively, index funds are an investment strategy with clearly defined rules of ownership that are held constant in spite of market conditions. However, among low cost index funds, risk exposure is more important than any fees associated to the fund. Therefore, investors should primarily consider the risk associated to the fund. Risk is the uncertainty of their expected returns. If they don't know what to expect, they won't be able to choose the right index fund to match their risk profile.