What is an Index Fund?💹

If you have your money invested with any robo advisors then chances are your money is being invested with an index fund.

What is an Index ?

To understand what an Index fund is we must first understand an Index. An Index is a grouping of stocks based on a set criteria. E.g the Dow jones is a grouping of Bluechip stocks which have a wider representation of how the US economy is doing. Index funds are very good as they offer a cheap way of accessing a broad market with huge diversifications. Most investors also don't have the time, expertise or interest to pick individual stocks well and to get a well rounded portfolio you will need to buy a lot of stocks which will require extensive research. Without index funds you will also need to constantly monitor the companies and industries that will have the best return so you know when to sell or buy a company stock.

When looking to build a well rounded portfolio with pick company stocks, you will have to pick company stocks with the best growth potential , you will also need to take into account competitive trends, economic events, political events and unforeseen events, this becomes even harder when you imagine doing this for thousands of company stocks .

Research has show that is is very difficult for professional investors to buy and sell stocks which outperform the market on a consistent basis. The best way to build an investment portfolio which will grow and be very diversified by containing thousands of stocks from different industries will be to get an index fund.

What is an Index fund?

An index fund is a basket of stocks which contain the same number of stocks in a particular index( e.g the S & P 500)

In any event, an index fund is simply a mutual fund that, instead of having a portfolio manager making selections, outsources the capital allocation job to the individual or committee determining the index methodology e.g the committee which selects the S & P 5OO methodology. This is because whatever stocks are included in the index will also be included in your index fund.

Examples of Indexes include the S&P 500, The NASDAQ or the DOW JONES.

You cannot invest directly in an index fund but rather you can invest in an index by buying index funds through an ETF or a mutual fund which tracks a specific index by holding a proportionate amount of stocks to replicate the price movement of the index. You can buy mutual funds or ETFs in the same way you buy stocks on the stock exchange. This will give you exposure to whichever index the mutual fund or ETF focuses on.

So e.g If you buy an S&P 500 index fund, you're really just handing over the job of managing your money to a handful of people at Standard and Poor's. In the end, you still own a portfolio of individual stocks, it's just held in a pooled structure with a portfolio manager over it who is responsible for getting results as close to the index as possible (known as "tracking"). Index funds aim to replicate the movement of a chosen index in the stock market.

The advantages of Index funds

Index funds help investors save a lot of money on commission charges as they don't have to buy 30 or 50 individual stocks( and pay commission on each transaction) but rather they buy shares into one index which give them the same exposure as the index. An ETF index fund could cost as low as 0.03% in annual management fees. For a £10,000 investment you will pay £3 for the whole year.

Second, many index funds in the equity market tend to be run in a way that minimizes turnover. Low-turnover, or high passivity depending upon how you prefer to phrase it, has long been a key to successful investing. In fact, there is a tremendous body of research that shows investors would be better off in many cases buying the underlying index components directly, as individual stocks, and sitting on them with no subsequent changes at all than they would be by investing in the index fund itself

Thirdly, Index funds have lower management costs than other investment vehicles.

Finally, Index funds allow you to diversify.

Disadvantages of index funds

There are no tax shelters for most index funds except you invest via your ISA allowance.

Another drawback of index funds is that they are not intelligently representative of different sectors. E.g the S&P 500 is weighted too much towards financial companies.

In other words, take index funds for what they are: a potentially wonderful tool that can save you a lot of money and help you get a good foundation underneath you. Once you are wealthy enough to have some real money behind you, consider bypassing the pooled structure entirely and owning the underlying components.

Beyond that, index funds are neither friend nor foe, virtuous or evil. They are a tool. Nothing more, nothing less. Use them when it suits you and is to your advantage, avoid them when they don't and aren't. Don't get emotionally attached to them or somehow be seduced by the lie that there is something magical about their structure that makes them superior to all else in the universe.

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