Index Funds guide | Guide to Index Funds: Everything You Need to Know| Advantages and Disadvantages Index Fund Investing NEWS AND WEALTH

Index Fund Investing| What are Index Funds| How does Index Funds work

In today’s world of ever-evolving finance, the concept of investing may sound complex and confusing for many. Whether you are a new stock market investor or already a seasoned investor, understanding the fundamentals of Index fund is very crucial. The term Index Funds and Exchange Traded Funds (ETF) are gaining a lot of popularity, and rightly so as they do offer a lot of simplicity and diversity to the ultimate investor.

Today in this article, we will cover fundamental topics related to Index fund, such as What is an Index? How Does an Index Fund Work? Advantages and Disadvantages of Index Funds and Types of Index Funds, so lets deep dive in today’s article.

What is an Index?

To understand the context of an Index, you can think about it as a group of Stocks, Bonds or other securities that do represent a particular segment or category of financial market. For example, the S&P 500 is an Index, which comprises of the 500 largest publicly traded companies in United States. I

In above example, S&P 500 acts are a benchmark for the performance of largest publicly traded companies in United States and in-turn acts ad a performance indicator for United States Stock market.

It is worth noting that, You cannot directly invest in an Index. However, you have to select an investment instrument such as an Index Fund or a Exchange Traded Funds.

What is an Index Fund?

An Index Fund is a fund in which an individual can invest their money directly. This Index Fund is managed by Fund manager who accumulates the money and provide the investor with units of the fund in proportionate of their investment. The money is then invested in the stocks in proportionate of the stock weightage in the Index.

The main objective of an Index Fund is to replicate the performance of an Index.
As fund manager does not have to conduct market research, therefore the expense ratio or the charge of their service Is the least among various categories of the fund.

How Does an Index Fund Work?

An Index fund is an investment instrument which aims to replicate the performance of the specific index on which it is based on.

For example, if you want to invest in S&P 500, Then the Fund manager of S&P 500 Index will purchase the shares in all the 500 companies included in S&P 500 Index. Due to this structure, the performance of the Index Fund will mirror that of S&P 500 Index. If S&P 500 Index goes up by 1%, then S&P 500 Index Fund will also rise by approximately 1% or vice versa.

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Pros and Cons of Index Funds

Investing in a Financial instruments does have its pros and cons, It is very important for an Investor to understand both the Advantages and Disadvantages of investing in Index Funds.

Advantages of investing in Index Funds.

Passive Investment: Index Funds offers their investor with passive style of investment. This means, if an investor doesn’t have time to do market research and analysis particular stocks, then he can be stress-free and invest in broad market by investing in a Index fund. By investing in an Index fund, investor is betting on the market and not a particular stock, and historically markets have always shown a positive return.

Low ticket Size: Index funds do provide its investor with the lease expensive investment option than almost any other kind of investing available in market. You can start investing in Index fund with no minimum required investment.

Diversification: Diversification is the biggest advantage of investing in an Index Fund. Index fund provides their investor with most effective diversification option which exposes its investor with broad range of companies or bonds and not just a particular stock which may have very high volatility. This helps its investor to reduce risk and have a balanced portfolio.

Low Cost: Index Funds do have low management fees and expense ratio as compared to an actively managed mutual Funds. This is because, the fund manager does not conduct market research and only has to replicate the Index fund with no additional research.

Lower cost means you will save additional dollars, which stays invested and compounded over time making you much wealthier with time

Disadvantage of investing in Index Funds

Can’t Beat Index: One of the biggest drawback of investing in Index fund is that, you will never enjoy higher returns then it’s benchmark.

Lack of Flexibility: You will not be able to choose the stocks your money is invested. When you decide to invest in a index fund, you will buy whole index and not shares. If you want to buy only a particular share, you cant invest in it via index fund.

Tracking Error: Any index fund cannot perfectly replicate and copy its benchmark index. This is due to many reasons, majorly as a fund manager has to set apart a particular percentage of its Asset Under Management or Investment in cash and cash equivalents instruments. This is to satisfy any redemption requirement requested by fund investors.

Types of index funds

There are different types of index funds which are based on the index they track or an Investment theme they follow, which we have mentioned below.

Market-cap based index funds

Market-cap based index funds are the funds which do investment based on the market capitalization of a company. Market capitalization can be calculated by multiplying Price of a share multiply with Total outstanding shares ( Shares * Price ).

In this market-cap-weighted index, companies with higher valuations do have higher weightage in the index.

Sector Specific Funds

Sector-Specific Index Funds are funds which do their investments in a particular market sector.

If you wish to invest in a particular sector such as Consumer Sector, Banking Sector, Technology Sector, Healthcare sector, Real Estate Sector etc then you can chooses to invest in Sector-Specific Index Funds.

Fixed-Income Index Funds:

Fixed-Income Index Funds are funds who invest in fixed income instruments and not stock market.

These funds provide safety to an individual’s portfolio by avoiding volatility of stock market and generating much safer returns with fixed income instruments such as bonds.

Commodity Index Finds

Commodity Index Funds do their investments in various commodities such as gold, silver, oil etc. Its main objective is to replicate their performance to its commodity’s performance.

Commodity investing do provide its investors with hedge against its stock portfolios, as in the bearish environment, investors historically move their money from stock market to safe assets like gold and silver.

Conclusion

In conclusion, we can say that index fund investing do offer its investor with a simplistic, straightforward and practical approach to invest in financial markets. While investing in Index funds will not generate the highest returns, but you will enjoy dependable returns, diversification and low cost investing benefits. Your decision to invest in Index funds should align with your investment goal and strategies, risk tolerance and time commitment. Please consult with your financial advisor before making any financial decision.

Investopedia’s article on Index Funds – Click Here