An index fund is a type of mutual fund that has a portfolio which tracks and mirrors the components and performance of a market index. Examples include the Standard & Poorâ€™s 500 Index (S&P500), Russell 2000 (small companies), the FTSE 100 and the Lehman Aggregate Bond Index (total bond market).
Indexes are useful to gauge a nationâ€™s wealth. It also serves as a benchmark for managing mutual funds. Index funds are created using indexing methodologies, which attempt to weight all the securities in the index fund to mirror the target index composition as closely as possible. They also mirror the performance of the index on which they are based.
How are Index Funds Traded?
While trading in index funds offers broad market exposure, it involves low operating expenses. The reason for low expense ratio is because most index funds are not actively managed. This type of model is called passive fund management.
Index funds are based on a theory known as the efficient market hypothesis (EFH). This theory states that as stocks are valued with accuracy, it is not possible to beat the market easily.
Benefits of an Index Fund
- As index funds are managed passively, its operating expenses are low.
- A broad index tends to be less volatile compared to specific sectors or stocks. This further means that an investor has less risk.
- The costs for running an index fund are much lesser than that of mutual funds.
- Index funds outperform most of the actively managed mutual funds.
- Index funds are tax friendly so you can earn substantial tax savings.
Risks of an Index Fund
- It is not possible to mirror the target index precisely since the mirroring and sampling models cannot be 100% accurate.
- As the fund is designed to match the target index; it will not outperform the index.
- A change in the composition of the target index may lead to a decline in the return on investment.
Despite these risks, investors continue to invest in index funds. To check whether your portfolioâ€™s performance is good or bad, measure it against an appropriate benchmark.