Index Mutual Funds or Mutual Index Funds

A sensible option for time poor investors?

Index mutual funds, also known as mutual index funds, passive funds or index trackers, match the performance of an index of a specific financial market.

A variation of this type of fund characterized as Yield Tilt is a type of mutual fund that replicates the holdings of a particular stock index.

Except in this case, the fund weights its holdings towards stocks that offer higher dividend yields.

Stocks with higher dividend yields are given a greater portfolio weighting.

Equity (Stock) Index Funds

This type of fund relate specifically to the stock market and invests its money into the market in a way determined by a stock market index.

The fund manager does minimal further trading other than making adjustments as stock weightings alter.

The fund manager makes no judgements about companies or future market movements. The manager only seeks to accurately reflect the index they are tracking.

For example, Dow Jones index funds 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.

Types of Index Mutual Funds

There are a wide variety of index funds available to investors.Index funds can be found in terms of ...

  • the country of origin e.g., China index funds
  • commodities e.g., commodity index funds
  • a particular resource type e.g., gold index funds
  • a particular stock market e.g., Dow Jones index funds
  • the global reach of the fund e.g., international index funds
  • by value investing style e.g., value index funds
  • whether shares are sold with or without a commission or sales charge e.g., no load index funds
  • real estate index funds e.g., REIT index funds
  • the company that is selling them e.g., Vanguard index funds.

Advantages and Disadvantages of Index Mutual Funds

The advantage of these funds is the very low expenses compared to 'active' funds, since it doesn't cost much to run this type of fund.

They are also a useful option 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. They are like air planes, great when they are rising and worrying when they are falling.

The fees charged, although usually low, will still reduce the return to the investor relative to the index.

Tracking Error

It is impossible to precisely mirror the index because of the sampling involved and the daily movement of stock prices.

The degree of variation from the stock market index is referred to as the tracking error.

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.

Effect on Companies

As companies grow and increase their market capitalization, 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 and are not easy to accumulate when value investing.

To Conclude

I have not invested in index mutual funds but would prefer them ahead of 'active' funds because of the lower fees and historically better returns.

While there are funds referred to as value index funds, the name does not necessarily imply a value investing approach.

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