What is an Index Fund?

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Most investment and financial planning experts agree that a mutual fund is an ideal way to maximize the potential of your investment while at the same diversifying your portfolio and reducing your risk. This is because a mutual fund is a collective effort – rather than you as the individual investor selecting stocks or bonds or other investment vehicles in which you’d place your money, instead you give your money to a mutual fund manager. The manager takes all the money that all of the investors have given the fund, and then uses that money to buy quantities of shares in a variety of investments. In this way, by making one investment, you are able to own shares of stock from across the board. This is automatic diversification – if one company that the fund holds does poorly, it is a good bet that another of the myriad investments will do well. On the other hand, if you bought stock on your own, and it performed poorly, you would simply lose money.

The bet here is that the mutual fund manager is going to a better job than you in selecting stocks – this is their profession after all – and at the end of the year the return on the fund will depend on how well the manager predicted the markets. There are many kinds of mutual funds – large-cap, mid-cap, small-cap, aggressive-growth, etc. The list goes on and on, and sometimes it is difficult to know what kind of fund is best for you. Investment experts crow about the benefits of each type of these funds, but the fact of the matter is that unless the mutual fund manager is exceptional, there is little chance that he or she is going to do better than the market indexes themselves. In fact, it is estimated that only about 20% of actively managed funds have done better than the stock market average over the past two decades. If the idea of putting your money in the hands of a mutual fund manager who tries to beat the market sounds like too risky a proposition for you, then an index fund may be the answer.

An index fund is really quite simple in its premise: the investments in the fund are designed to behave as the market does as closely as possible. This is done by selecting an index – the S&P 500 and the NADSAQ 100 being two of the most popular, though others exist – and then buying shares in companies listed in that index at about the same ratio as they exist in the market. This takes the guesswork and the predictive element out of the fund’s investing practice. In fact, most of these funds are run by computers and a small support staff, since the buying and selling of shares are based purely on another quantifiable index. This has a number of advantages for investors.

First, index funds are cheaper than regular mutual funds. This is because mutual fund managers make millions of dollars a year to handle your money, and their support staff costs millions of dollars per year as well. This money needs to come from somewhere, and unfortunately, it usually comes from the investor in the form of a high expense ratio. While the expense ratio for some mutual funds can be between three and four percent, index funds are usually less than one percent. A matter of a few percentage points may not seem like a big deal at first, but consider that the money is coming out of your pocket – and your future earnings. That small percentage can actually translate into tens of thousands of dollars over the long term.

Second, index funds have a lot less risk, and actually on average make more money. While the upside to risk is that the payoff can be greater, the downside is that the losses can be considerable. Because index funds merely ape a chosen index, there is no chance that a manager is going to blow your investment by suddenly believing that cathode ray televisions are going to become popular again. As mentioned earlier, it is extremely difficult to “beat the market” (which is why mutual fund managers earn such egregious salaries), and for eighty percent of these highly paid managers, it has consistently proven too difficult to do. In fact, over the past two decades, the average return on the market has been about 13%, while the average return on a mutual fund has been about 11%, which makes index funds seem even more appealing.

One disadvantage to index funds is that they are more of a slow-growth investment. If you are the type of investor who likes to get in and out of the market, buying and selling frequently, index funds may not be for you. Because the market has traditionally grown slowly over the years, with very few years of seeing massive returns or losses, index funds are perfect for people who have a number of years to let their money mature. For this reason, many experts recommend index funds as part of a retirement portfolio, especially if you are fairly young.

Index funds are certainly not the most glamorous of investments. However, they consistently provide a better return than most mutual funds, providing all of the benefits of those investments without the risk.

Related Post:

• Guide to Mutual Fund Investment
• Mutual Funds