Index funds - a sensible option for
beginning and time poor investors
Index funds, also known as passive funds or index trackers, match the performance of an index of a specific financial market. Equity index funds relate to the stock market.
This type of fund invests its money into the market in a way determined by some stock market index and does minimal further trading other than making adjustments as stock weightings alter.
The fund manager makes no judgements about companies or future market movements, they only seek to accurately reflect the index they are tracking.
For example, a fund based on the Dow Jones Industrial Average would buy shares in the stocks that make up the Dow, only buying or selling shares as needed to invest new money or to cash out investors.
The advantage of these funds is the very low expenses compared to 'active' funds, since it doesn't cost much to run one.
They are also useful options for people who would like exposure to the share market but who do not have the time or inclination to develop the skills to make rational buying and selling decisions.
The disadvantage is that the fund suffers when there is a significant downturn in the stock market.
The fees charged will always reduce the return to the investor relative to the index.
In addition it is impossible to precisely mirror the index because of the sampling involved and the daily movement of stock prices.
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The degree of variation from the stock market index is referred to as the tracking error.
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So if a particular market achieves a historical return in the region of say 12%, that is what you can expect to get, minus fees, over the longer term.
As companies grow and increase their market capitalisation, the funds may become obliged to buy the company's stock because the company size starts to have an effect on the index.
This can result in boosting the price of the company's shares.
While this makes the directors of the company happy, it may artificially inflate the share price and hence overvalue the company.
This is one reason why larger companies tend to be overvalued more often than not.
I have not invested in index funds but would prefer them ahead of 'active' funds because of the lower fees and historical better returns.
Return from Index Funds to Managed Share Funds
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