Definition of Index Fund
An index fund a type of a (passively managed) mutual fund (MF) or an exchange traded fund (ETF) which consists of portfolios that reflect or replicate or follows the performance as well as exposure of the index of any country such as S&P 500 Index or NASDAQ Index or Nifty Index, etc. and provides the investor with the risk & returns by mimicking the index.
- A good portfolio is reflected by the diversification it contains. The returns are said to be stable when the investments are diversified into various investment streams. Such diversification is made to minimize the risk. The concept of diversification in stocks of different sectors is borrowed by a mutual fund. So, we have the concept of index funds.
- Thus, the index fund managed passively so that it reflects the same proportion of as the market portfolio.
- An index fund is therefore a portfolio of stocks in different sectors of the economy.
How Does It Works?
- Index funds is not about active fund management wherein the investor actively wisely chooses the securities with attention on the timing of buying & selling the stock. No, it is not case with index funds. Rather, these funds are managed passively.
- The fund here mimics the index of the country i.e. the entire market. This means it will match the risk & return portfolio of the market. This comes with huge volatility than individual stocks.
- In the United States of America, the index funds majorly follow the S&P 500 Index. However, one should note that there are other indexes as well which are used as the basis for mimics:
- Dow Jones Industrial Average (DJIA): It is an index representing 30 large-cap companies in the US
- Morgan Stanley Capital International for Europe, Australia & Far East (MSCI EAFE): It is an index representing the most productive & profitable stocks of the EAFE regions.
- Russell 2000: It is an index created in 1984 by the Frank Russell Company. It comprises of 2000 small-caps.
- Barclays Capital U.S. Aggregate Bond Index: It represents an intermediate-term of bonds traded in the US.
- So, there are many indexes that can be followed.
- The portfolio manager may choose to follow a weighted index of securities. In this case, the manager re-balances the percentages to reflect the stocks or bonds available in an index.
Example of Index Fund
Let us discuss a few index funds on a broader basis.
- Vanguard S&P 500 ETF: It follows the movements in the S&P 500 index. As of July 2020 (latest), the total assets are $ 560 billion. This is an exchange traded fund that began its trading in the year 2010. Vanguard is the fund industry. It is one of the largest funds. Here, the expense ratio is 0.03%, which means if you invest $ 100,000, it would cost only $ 30 per annum.
- Fidelity Zero Large Cap Index: It is popularly known as FNILX. The best thing about this index fund is that the expense ratio is NIL i.e. zero as suggested in its name. It follows the Fidelity US Large Cap. The expense ratio is lower since this fund does not have to pay license fees for using the name of S&P. This implies that if an investor invests $ 100,000, it would cost him nothing per annum. All returns earned are in the pocket of the investor.
- Schwab S&P 500 Index: It is popularly known as SWPPX. The expense ratio here is 0.02%. As of August 2020 (latest), it has $ 47 billion of assets. The index is sponsored by Charles Schwab. He is one of the most respected persons in the industry with his image being providing investor-friendly products. It started in the year 1997. The expense ratio is attractive.
- SPDR S&P 500 ETF Trust: It is founded in the year 1993 & it has an expense ratio of nearly 0.09%. It has assets of about $ 306 billion as of August 2020 & it is the most popular exchange-traded fund. It follows the S&P 500 index as suggested by its name. The expense ratio is higher making it cost $ 90 for investor who wish to invest $ 100,000.
- iShares Core S&P 500 ETF: This fund is sponsored by BlackRock & it has assets to the tune of $ 219 billion as per the latest figures in August 2020. It started in the year 2000 & thus it has a long tenure of work. It has an expense ratio of 0.03% making it cost $ 30 for an investor who wish to invest $ 100,000
Who Should Invest in an Index Fund?
The indexes over the globes are mostly predicted with the help of technical software or fundament sources. Thus, the investor category who likes predictable returns may prefer to invest in such funds. Index fund normally gives approximate returns which are reflected by the index. Since the performances are predictable, the fund manager churns the composition accordingly. However, on should note that, since the index fund is managed with a passive approach, the return profile of the index fund will be as greater as offered by the actual index. In case an investor seeks to have ample return quantum of returns, he should suggestively invest in actively managed funds.
Some of the advantages are given below:
- The new investors are easily attracted to these types of funds.
- Index funds are normally preferred these days and are hugely popular due to the fact that the fund managers can manage to beat the benchmark the market refunds through these funds, which is normally difficult in case the market becomes more effective.
- Index funds are passively managed & thus, they do not need any active management as such.
- Index funds have lower costs due to their expense ratio.
- The investment is made through a bunch of assets (i.e. a bunch of stocks) together & thus the index funds do not have to worry a lot about the risk associated to any specific stock. Adverse movements in one stock is compensated by favourable movement in another stocks.
- Underperforming stocks are automatically removed by the index.
Some of the disadvantages are given below:
- The investor basically retains no control over the performance of the index. Thus, he cannot use his own strategies to gain up.
- As said earlier, the index funds mimic the index it is following. In the case of the downside trend of the main index, there is no protection from the loss.
- The correlation of the index fund with the market is very high. Thus, even it has the potential to gain as per the market, it is equally exposed to loss due to the market downturn.
- Thus, investors with lower risk appetite are suggested to think strategically before investing in index funds.
- Index funds do not enjoy flexibility and discretion since they are regulated by various policies & procedures.
- Since index funds are passively managed, the investor should not expect massive gains through such investment.
You cannot invest in each & every share of the economy. However, an index fund makes it possible for even an individual through its units. Investors can enjoy the benefit of diversification at a lower cost. It is the skill of the fund manager who choses which stocks are to be included in the index fund. However, no such discretionary right is given to the investor. Due to direct correlation with the market, over the long-term years, such funds have performed massively.
This is a guide to Index Fund. Here we also discuss the definition and examples of index fund along with advantages and disadvantages. You may also have a look at the following articles to learn more –