An Index Fund, otherwise known as Index Tracker, is a collective investment scheme that aims to follow the movements of an index of a specific financial market. This entails the practice of adjusting a portfolio so that its performance mirrors that of the market index. The collective investment scheme may include mutual funds or managed funds. By market you may understand Dow Jones Industrial Average, NASDAQ, and FTSE 100, DAX or any other pertaining to your geographical location. Collective investments often tend to target specific geographical section, such as emerging markets, or industry. The trend of index fund commenced with John Bogle who set The Vanguard Group in 1974. It is now one of the largest mutual fund companies of US.
While discussing Index Funds, it is better to understand a bit about Active and Passive Management. Active Management considerably depends on the ability of picking stocks and timing. Most mutual funds fall under this category. Passive Management, on the other hand, denotes an approach that does not involve the rush of beating the market. Instead, it tries to manage the risk in order to guarantee the return. Apart from traditional indexing two other types of indexing methods are followed nowadays. These are called synthetic and enhanced indexing methods. Without going into much complications we may say, synthetic indexing is a modern practice of blending equity index futures contracts with low risk bonds to replicate the performance of the market. Enhanced indexing aggressively uses active management principles to ensure performance. Any type of improvements may be a part of enhanced indexing. Generally speaking, strategies of enhancement involve sector and quality repositioning or issue selection.
Benefits of Index Funds
As an investor two things would naturally concern you most – the benefits of Index Funds and the risks associated with it. Let us discuss the benefits of such type of investment first. The low expense ratio is the highlight of these types of funds. Index Funds do not have sales charges that make it further attractive. However, mutual funds do have sales charges more often than not. Moreover, there are attractive tax benefits depending on the laws of a country that could be claimed. For those who really wish to make a difference at a social or environmental level may opt for socially responsible investment strategy also known as ethical investment. Your funds may be utilised at many level starting from developing ecologically sustainable products to setting up of infrastructure for research on alternate sources of energy. Renewable energy investment, Forestry investment etc. are some of them. In fact renewable energy investment created quite a buzz in 2013. Self-Invested Personal Pension or SIPP investment, besides helping to secure one’s future, can provide great tax benefits. As a mean of promoting sustainable forestry you may also think of teak investments as a part of your investment planning. Teak investment may also prove to be far more consistent, safer and predictable investment with significant return over other traditional means of index funds.
Risks Associated with Index Funds
There are certain inherent risks associated with any type of investment and index funds are no different in this regard. One criticism against index fund that is often heard is, the return would eternally be identical to the market it is tracking. Actively managed funds tend to outperform most of the mutual funds in the longer run that are not actively managed. Be wary of excessive replacement and tax inefficiency of your investment. Some indices, such as S&P FTSE 100 and S&P 500 are spearheaded by renowned company stocks. Your index fund may or may not match their day to trend always. Resolve to be patient if you are seeking profit through green investment.
Let us risk redundancy once again by emphasising how important diversification is. It massively helps in reducing the impact of volatility in the market. Discuss with an expert financial advisor and do a bit of research of your own before deciding on your asset allocation. It will help you choose a wide array of well-balanced asset classes that you may not have otherwise thought of.