What are Index Funds?
Index Funds is a form of mutual fund constructed to replicate and match the exposure and performance of a particular index of a country like S&P, NASDAQ, etc., and helps investors take broad market exposure due to the amount being invested in various stocks from the different sectors of the economy.
Examples of Index Funds
Given below are some of the examples of indexes around the world.
- Russell 2000
- Wilshire: 5000
- Dow Jones Industrial Average (DJIA)
- FTSE All World Index
- Russell Global Index
Additionally, some index funds are listed as under
- Vanguard 500 index fund Investor Services
- Schwab S&P 500 index fund
- Fidelity 500 index fund
- T. Rowe Price Equity Index 500 fund
- VanguradTotal Stock Market Index
Features of Index Funds
There are many reasons index funds are favorites even of investment gurus like Warren Buffet and John Bogle, and the underlying reason for the same is listed in its advantages below:
- Lower Cost: Compared to actively managed mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks. where there is portfolio churning regularly, an index fund is passively managed with not many transactions. Hence this reduces the significant expense ratios of such index funds.
- Automatic Rebalance: Since an index fund goes on to track and replicate the index of any country and thus it is but natural that it will go on to include the top winners and automatically clean up the portfolio by removing the underperformers. Hence there is an automatic rebalancing that takes place with little or no active management from the fund manager.
- Diversification: There will be no sector or security-specific risk. Since a broad-based index covers various areas or sectors of the economy, an index fund that replicates the same goes on to have the advantage of diversification. A slowdown in a particular sector will not significantly impact the fund as a whole. Since the investment, in this case, is in a basket of securities, such funds will allow one to expose or bet on the broad market.
- Easy to Manage: There is little or no active management required from the side of the fund manager. He/she is not under constant pressure to generate alpha more than that of the index. The fund manager has to merely replicate the portfolio to that of the index. Hence there is minimal effort from the side of the fund manager, and thus this is a fund that is comparatively easy to manage.
- Well Suited to Efficient Markets: It is often noted that as markets become more efficient, i.e., the stock prices quickly and efficiently reflect and incorporate all of the information, there will be little scope to generate alpha or excess returns than the index, through the method of active investing.
- Passive Management: The manager of an index fund is merely seeking only to buy and hold securities And Hold SecuritiesThe term "buy and hold" refers to an investor's investment strategy in which they hold securities for a long period of time, ignoring the ups and downs in market price during a short period of time. that would represent the index and would go on to match its performance. Hence there is no risk of picking the wrong stocks or the possible fear of underperformance as in the case of actively managed funds.
Disadvantages of Index Funds
However, these funds have certain disadvantages, which are enlisted as under:
- Downside Correlation with the Market: Index funds do not stand to provide downside protection. Since the index fund portfolio is positively correlated with the market, the portfolio as a whole will observe a plummet whenever there is a market correctionA Market CorrectionMarket Correction is usually referred to as a fall of 10% or more from its latest high. It happens due to various reasons such as declining macro-economic factors, intense pessimism across the economy, securities specific factors, over-inflation in the markets, and so on.. Though there are considerable gains in the upside, however, an index fund leaves you significantly vulnerable to the downside
- Limited Exposure to Strategies: Since the investor has no control over the portfolio, he will not be able to have success with various strategies. There will be no discretion to buy value or growth stocks when an index merely happens to be replicated,
- No Big Gains: There is a possibility that an actively managed fund may go on to beat the market and bag impressive gains. This tends to lose out as an investor would usually surrender the possibility of such massive profits. Sometimes it does not carry the potential to outpace the markets and create alpha, the way some of the actively managed funds can
- Lack of Flexibility: Since index fund managers are under requirements to follow specific policies and procedures to perform in lockstep with that of the index, they may lack the discretion and flexibility to make specific changes in the portfolio as they deem fit
The fund manager has little or no control over the portfolio as they merely will tend to track and replicate the index. Hence there is no flexibility to experiment with specific strategies to beat the market and thereby generate alpha for the investors
Index funds tend to benefit the investors as they go on to have exposure to the entire economy owing to the broad base such funds usually do have. There will be diversification at a relatively low cost, and these seem to benefit the investor. Since it is passively managed, even the fund manager would find it pretty easy to balance contrast to an actively managed fund.
However, owing to limited control and lack of flexibility in having to choose over the stocks that go into and make up the portfolio, there tends to be a particular drawback, as, given the efficient skills of the fund manager, they may very well seek to beat the market and generate alpha for all of their investors.
Nevertheless, over the years, such funds have managed to gain immense popularity among the investing public owing to diversification and low-cost benefits since such funds give a return, which is directly correlated with that of the market.
This has been a guide to what are Index Funds and its Definition. Here we discuss examples of index funds along with advantages and disadvantages. You can learn more about Mutual Funds from the following articles –