Index Funds and How They Can Work for You

Apr 20, 2021 07:12 PM ET
Index Funds and How They Can Work for You

Index funds are mutual funds managed on behalf of a group of investors by a fund manager and linked to the performance of a financial index listed at a stock market. The term "mutual funds" refers to the fact that it is funded by a pool of investors.

How index funds work

Once investors select the index they would like to invest in. Their money is tied to the movement of the index for as long as they want to keep it locked. They are then able to earn through interest or dividends. In instances where they wish to cash out, they get their capital gains.

Types of index funds

The major index funds include:

  • Equity index funds. These are index funds whose yields are linked to a stock index such as NIKKEI, Dow Jones Industrial, Nasdaq Composite, S&P 500, and DAX.

  • Broad market index funds. These mimic the performance of investment markets such as the bond markets and other investment securities as a single unit. For example, an index fund may be linked to the performance of T-bills in the bond market.

  • Sector-specific index funds. As their name suggests, these are derived from the performance of indices of selected segments of the economy in the stock market. The sector may be consumables, industrial, etc.

  • Bond-linked index funds. These are tethered to bonds issued by local authorities, such as municipal bonds. Their performance thus depends on the yields obtained from such bonds.

To make well-informed investment decisions on index funds, it is of utmost importance that you understand the type of index you are dealing with. This will help you assess it against the segment(s) of the economy it represents and evaluate the likelihood that it will give you good returns.

Index examples

The S&P 500. Known in full as Standard & Poor's 500, this index is based on the performance of the largest 500 companies in the United States by market capitalization. It is among the world's most popular indices.

The Dow Jones Industrial Average. This index is derived from the performance of the top 30 companies in the United States.

Nasdaq Composite. This is a sector-specific index that tracks the performance of industrial firms listed at the Nasdaq Stock Exchange.

DAX. The index is based on the tracking of 30 specific companies listed at the Frankfurt Stock Exchange in Germany.

NIKKEI Index. This index incorporates the performance of a total of 255 companies whose stocks are traded at the Tokyo Stock Exchange in Japan.

Gaining from economies of scale, indices can withstand periodic shocks that frequently affect individual firms, leading to sharp declines in their stock prices. Consequently, index funds may make small gains over time, but will hardly report declines in earnings. On the other hand, investing in single company stock may give you super-normal profits when its stock price rises, but also make you lose a large chunk of your money if the stock price plunges.

Index funds are a straightforward way to invest and track. You only have a specific market index to follow, thereby freeing you from the burden of studying complex market trends and analysis.

A guide to investing in Index Funds

  • Understand how index funds work by reading broadly or seeking guidance from a successful investor or trader.

  • Determine how much money you would like to invest in an index fund. This should ideally be your disposable income because there is never a guarantee that you will reap a profit within the timeline you desire.

  • Know the minimum amount of money you are required to invest in different investment funds. Make comparisons, weigh your options and choose what works for you.

  • Get to know the fees you will incur for a particular account and select the most appropriate one.

  • Get a broker to help you set the wheels in motion.

What are the Advantages of Investing in index funds?

Minimal operational costs.  As discussed above, index funds' core interest is in a single index, which is all you have to track to know the status of your investment. This, therefore, means that you don't need expert analysts and traders to help you make the right calls. In the end, those who invest in index funds save a significant amount of money.

Almost-guaranteed good returns. Index funds are a good investment because, ultimately, they almost always return positive yields in the long term. The profit margins may be relatively small, but this is offset by the peace of mind that they offer investors, considering that they are low-risk ventures. The diversified nature of firms in a market index is what makes index funds an attractive investment.

Tax savings. Because index funds tend to hold on to their stock over long periods, they end up making significant savings on capital gains taxes. The more frequently you acquire different stocks, the more your taxes pile up.

The downside to index funds

Rigidity works against them. An index fund has a major disadvantage of sticking to an index even when the majority of firms in the index have underperforming stock. Unlike other investments, the fund manager, unfortunately, cannot dump bad stock for new ones. This may lead to reduced profits or losses.

The burden of the index. With index funds, investors' money is tethered to the market index. If the index underperforms, the investment underpays. This creates a situation whereby investors may feel trapped and frustrated even when some firms in the index are excelling.

Tracking error. There are times when an index fund will yield lower returns than the index. The technical name for this phenomenon is "tracking error." This is usually a result of the costs incurred in managing the assets. Therefore, be sure to look for the index fund whose tracking error is the smallest in that particular market index.

Conflict of interests. It is not unheard of for managers of index funds to also be the same persons managing some of the firms in an index market. This may lead to a conflict of interest between protecting the investors' interests and safeguarding the firm's interest, especially during critical decision-making periods. Often, it is the investors who end up on the losing end.

Final thoughts

Index funds offer great opportunities to make decent money because they rarely result in losses. They are simple and easy to understand. Their operational costs are also friendly to investors. However, they are ideal for long-term investment and may not give you large profit margins.



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