You might have heard of index funds and how they present a cheap and effective way to invest. An index mutual fund, or simply an index fund, is a kind of investment fund which try to duplicate the performance of a popular stock or bond market index.
It is considered as passively managed since the portfolio manager simply tries to replicate the success of a certain index of stocks, bonds and other investment instruments. The portfolio manager then builds a fund with the same set of assets in the index, or holding similar securities as that of a popular stock or bond market index.
For instance, S&P 500 fund will perform the same way as the S&P Index since it has all the stocks of the latter.
Aside from being cheap, the other selling point of index mutual funds is that it can outperform even actively managed mutual funds. In fact, the Vanguard 500 Index, a top index fund, was among the top performing mutual funds this year.
The growth of index mutual funds has been remarkable. A decade ago, passively managed products consisted less than 12 percent of the mutual fund and ETF assets in the United States. Fast forward to 12 years, and that level has increased to 27 percent and the percentage continues to rise.
It can be very tempting to invest in an index fund, but you must also know some of the truths about index funds such as:
Not Always Cheap
The truth is that not all index funds are cheap. In the past, index funds were inexpensive because these did not carry management fees and expenses from sales commissions. But the popularity of index funds has resulted to more intense competition, and consequently, increases in pricing.
For example, the Rydex S&P 500 has an expense ratio of 2.25% while the State Farm S&P 500 index fund has an expense ratio of 1.49%.
And although Vanguard 500 Index Fund has a low 0.15 expense ratio, it also has a minimum investment account which makes it quite difficult for a small investor to purchase any of its index funds.
Vanguard 500 and other more established funds have lower fees because of their experience in tracking indexes. Likewise these funds don’t need to raise their fees to support advertising and attract more investors.
Not Low Risk
The truth is that there is no such thing as risk-free investment instruments, and the same goes for index mutual funds.
Back in 2008, investors in an index fund that was tracking the S&P 500 lost by 37% including the funds’ expenses.
Not Always Translate to Investment Success
Just because you invested in an index fund means you are on your way to a more secured future. Like any other investment product, it is recommended that you use index funds in combination with other active funds.
Keep in mind that an indexed fund merely replicates the index it follows. Thus it would do as well or as badly as everyone else in the market. When the market is faring poorly your index fund would definitely be on the losing end as well. The same goes when the market is doing well.
Index funds can be an attractive investment vehicle due to its perceived affordability and low risk nature. However, as stated earlier, index funds are not always cheap and low risk.
If you are the type of investor satisfied with a slow earning pace, then an index fund may make sense to you. But if you are after big gains, you may find an index fund a poor fit in your portfolio.