Index Funds: Smartest way to investment

One of the simplest ways to invest and to get started building wealth is to buy Index Funds. Funds that track a market index, such as the S&P 500, Dow Jones Industrial Average are known as “Index Funds.”  In other words Index fund is a type of Mutual Fund or Exchange Traded Fund (ETF) that holds all of the securities in a specific index.  These funds typically use a passive investing strategy, which means their objective is to deliver returns similar to an index of investments. 

Index Funds and ETFs

However, Index funds usually deliver returns that are slightly lower than an index due to fees associated with these funds. In this article, we’ll discuss how index funds work, identify some of the indices these funds track, and examine the benefits and risks associated with this type of fund. 

Simply put, Index funds are built to have similar performance to that of a major market index. This means they tend to be diversified insecurities across that index and include a number of investments.

 There are many market indices, and index funds that follow them. According to Warren Buffet Instead of stock picking, it’s good to choose a low-cost Index fund. “I recommend the S&P 500 index fund”.

For example, if you want to invest in U.S. stocks, you might invest in a fund that tracks an index like the S&P 500, which follows the 500 largest stocks in the market. 


The S&P 500 is perhaps the most well-known index in the U.S. This Index uses a Market Capitalization weighted method, giving a higher percentage allocation to companies with the largest market cap. Here’s how the percentage allocation in the S&P 500 Index.

  1. Information Technology: 27.60%
  2. Health care: 13.44%
  3. Consumer discretionary: 12.70%
  4. Communication services: 10.79%
  5. Financials: 10.34%
  6. Industrial: 8.47%
  7. Consumer staples: 6.55%
  8. Utilities: 2.73%
  9. Materials: 2.64%
  10. Real estate: 2.41%
  11. Energy: 2.33%

The Dow Jones Industrial Average, which includes 30 large-cap industrial stocks; the NASDAQ-100, which follows 100 large-cap technology stocks; or the Russell 2000, which tracks 2,000 small-cap stocks. 

For international stocks, an example of a widely tracked index is the MSCI EAFE, which includes large-cap stocks in developed countries across Europe, Australia, and the Far East. For U.S. bonds, an example of a widely tracked index is the Barclays Capital Aggregate Bond Index, which includes a mix of Government Bonds, mortgage-backed securities, and corporate bonds with different maturities. 

Barclays Capital Bond Index

As you can see in these examples, Index funds can track different assets, including stocks and bonds. There are even index funds that follow commodities, currencies, and other assets. But regardless of which type of asset they track, an index fund still has its risks. 

Put simply, index funds are exposed to the same risks as the index they’re following. For instance, if the S&P 500 declines in value, then the index funds which track it will follow suit. An index fund that tracks bonds is at risk if interest rates rise and bonds decline in value. 

Some investors are willing to accept these risks and choose to invest in index funds because of the potential benefits they might offer. 

The Benefits of Index Funds


A primary benefit is the typically lower expense ratio— which means Index funds include low fees. Which is the ongoing cost of investing in the fund—compared to actively managed funds. As the name implies, actively managed funds use an active investing strategy. This means that they frequently buy and sell investments. 

 

The total expense ratio is the ratio of the total cost of running and managing the fund to its average Assets Under Management (AUM).

           

             Total Expense Ratio = Total Costs/Average Assets Under Management

This typically results in higher costs, expense ratios, and can be a drag on a portfolio’s performance over time. Because Index funds are passively managed and simply track an index, they generally have a low portfolio turnover, which means they infrequently buy and sell investments. 

That’s why most smart investors should always compare expenses when they choose the funds. This is often far lower for Index funds compared with Active funds.

Infrequent buying and selling typically translate into low expense ratios. The low expense ratios of index funds can possibly lead to more growth when compared to the higher expense ratios of similar actively managed funds. 

Let’s look at an example. Suppose an investor purchases $50,000 of two funds that both grow 7% per year – Before expenses – over the next 30 years. The funds are similar in all respects except the expense ratio.

Fund A is an actively managed fund with an expense ratio of 1.2%. This fund would grow to  $271,356. Fund B is an index fund with an expense ratio of 0.2%. This fund would grow to $359,838. That’s a  huge difference of $88,482, and it’ll be thanking a Low Expense ratio.

Expense ratio fees

The low cost of passively managed index funds can make a difference and is a reason index funds may outperform actively managed funds over long time periods. In Long Term Investing, Index funds have generally outperformed other types of mutual funds. 

Other benefits of Index funds are tax advantages (they generate less taxable income), and low risk (since they’re highly diversified). In short Index funds track a market index and are passively managed, also they are less volatile than actively managed Mutual Funds. So the risks are lower.

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