Index funds are collective investment scheme - usually mutual funds - whose objective is to closely follow the performance of an index of the financial market. For example, the infamous Vanguard S&P 500 index fund track the S&P 500 largest public companies based in the US (I know, their naming is creative). The fund holds stocks across those 500, in the same proportion as the famous index it is named from. It works like a mimic.
How do they work?
Most of them work like your usual mutual funds; each fund has a price - Net Asset Value – and is traded on a daily basis. They also charge for management fees, trading costs, and may distribute dividends and/or capital gains.
How are they different?
They are considered passive as their manager simply follow the index as closely as possible; they do not try to cherry pick the stocks they hold like usual mutual funds. They do not need to have battalions of analyst to uncover potential hidden gem on the stock markets. Many index funds have little or no human input in the decision thanks to the index they are tracking and the use of computer model to follow them.
What does this means for you?
Firstly, this means that you exactly know what you are investing in when chosing such funds. They are very diversified, and are a very good base to build a portfolio upon as their diversification is very good.
Secondly, your trading costs should be much reduced thanks to low stocks turnover - Indexes do not change on a regular basis, and their components are stable. Striking two birds with one stone, this will also helps avoid capital gains taxes. Their low turnover means that the fund will less frequently need to sell stock to accommodate index changes, saving you the trouble of dealing with these tax liabilities.
Thirdly, thanks to their little human input, the management fees are much reduced – the manager’s job being much simplified. As an example, the Vanguard S&P 500 has a very expensive ratio of 0.1%. You can’t really beat that.
These cost savings can be quite substantial. You can sometimes saves as much as 3 to 5 percent in return per year when comparing with some actively managed funds. Of course you may not have the pleasure to brag about how your portfolio beat the indexes. But you are sure not to have to see your nice double digit returns being eaten up by expensive fees.
Sounds great – but what are the caveats?
Of course, you guessed from the hereabove that I quite like index funds. While I think they are great, you may encounter potential hiccups. What could they be?
First, you will certainly not outperform the market as the funds try to match them. Some discrepancies may happen, but they usually are because of errors in tracking – our second point.
Secondly, some funds don’t track their index as perfectly as you would wish they do. They may take a little time to match changes in their index, or their cash position is sufficient to tamper their performance.
Thirdly, even though indexes are pretty stable, their composition changes over time. As an example a company like Google was not indexed only a few years back. The S&P 500 index has a typical turnover of between 1% and 9% per year. In effect, the fund manager will have to sell its position in markets that fell out of the index and buy the replacing ones so as match the new index.
Finally, following indexes means that you will also enjoy the ups and downs of the tracked index. You will therefore not be fully protected when global market go south. But your diversified investment is a great way to dilute your risks.
At the end of the day…
As said earlier, index funds are great tools to build a portfolio upon. The success of the Vanguard S&P 500 index fund is an example of the investors love for such product. This fund is present in so many investor’s portfolio that it has even more assets under management than Fidelity’s massive Magellan Fund. Quite a statement !
