Question

• Briefly describe how an Index Fund differs from a traditional Mutual Fund.
• Detail the the advantages and disadvantages of Index Funds?
• To what type of Investor would an Index Fund be most attractive?

Answer 1

a) How an Index Fund differs from a traditional Mutual Fund.

What Is an Index Fund?

An index fund is a type of mutual fund with a portfolio developed to match or track the parts of a budgetary market record, for example, the Standard and Poor's 500 Index (S&P 500). A file common reserve is said to give wide market introduction, low working costs and low portfolio turnover. These assets follow their benchmark list regardless of the condition of the business sectors.

Index fund are commonly viewed as perfect center portfolio property for retirement accounts, for example, singular retirement accounts (IRAs) and 401(k) accounts. Amazing financial specialist Warren Buffett has suggested index fund as a shelter for investment funds for the dusk long periods of life. Instead of choosing singular stocks for venture, he has stated, it bodes well for the normal speculator to purchase the entirety of the S&P 500 organizations at the minimal effort a index fund offers.

KEY TAKEAWAYS

• An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.
• A index fund is an arrangement of stocks or securities intended to emulate the piece and execution of a budgetary market file.
• Index fund/File finances follow a detached speculation technique.
• Index fund look to coordinate the hazard and return of the market, on the hypothesis that long haul, the market will outflank any single venture.

How an Index Fund Works

"Indexing" is a type of passive fund management. Rather than a reserve portfolio chief effectively stock picking and market timing—that is, picking protections to put resources into and planning when to purchase and sell them—the store administrator constructs a portfolio whose property reflect the protections of a specific record. The thought is that by copying the profile of the list—the securities exchange overall, or an expansive fragment of it—the store will coordinate its presentation also.

What Is a Mutual Fund?

A mutual fund is a sort of budgetary vehicle made up of a pool of cash gathered from numerous speculators to put resources into protections like stocks, securities, currency showcase instruments, and different resources. mutual fund are worked by proficient cash directors, who designate the store's advantages and endeavor to deliver capital additions or salary for the reserve's financial specialists. A mutual fund's portfolio is organized and kept up to coordinate the speculation goals expressed in its outline.

Mutual fund give little or individual speculators access to expertly oversaw arrangement of values, bonds, and different protections. Every investor, in this way, takes an interest relatively in the increases or misfortunes of the store/fund. mutual fund put resources into an immense number of protections, and execution is typically followed as the adjustment in the absolute market top of the store—determined by the collecting execution of the basic speculations.

Key Takeaways

• A mutual fund is a sort of venture vehicle comprising of an arrangement of stocks, bonds, or different protections.
• Mutual fund give little or individual financial specialists access to expanded, expertly oversaw portfolios at a low cost.
• Mutual fund are partitioned into a few sorts of classes, speaking to the sorts of protections they put resources into, their venture goals, and the kind of profits they look for.
• mutual fund charge yearly expenses (called cost proportions) and, sometimes, commissions, which can influence their general returns.
• The mind lion's share of cash in business supported retirement plans goes into mutual fund.

How Mutual Funds Work

A mutual fund is both a speculation and a real organization. This double nature may appear to be odd, yet it is the same as how a portion of AAPL is a portrayal of Apple Inc. At the point when a financial specialist purchases Apple stock, he is purchasing fractional responsibility for organization and its benefits. Thus, a mutual fund financial specialist is purchasing incomplete responsibility for mutual fund organization and its benefits. The thing that matters is that Apple is in the matter of making creative gadgets and tablets, while a mutual fund organization is in the matter of making ventures.

How are index funds different from mutual funds?

Index funds are passive in management which means they are not effectively exchanging or including ventures. Then again, mutual funds are dynamic in their administration style - implying that finance directors or examiners are effectively picking store property (like individual stocks, bonds or different protections).

So, what are the main differences between index funds and mutual funds?

Investments

Both index funds and mutual funds are typically comprised of stocks, bonds and other securities.

As is a given in the name, index funds focus on tracking the stocks that compose various indexes like the Nasdaq or S&P 500.

Management Style

One of the major differences between an index fund and a mutual fund (especially an actively-managed one) is their management style - namely, whether they are active or passive.

Index funds are passive in management - meaning they are not actively trading or adding investments. Index funds are automated to track with a benchmark index like the S&P 500, so their investment mix is dependent on the underlying index.

On the other hand, mutual funds are active in their management style - meaning that fund managers or analysts are actively picking fund holdings (like individual stocks, bonds or other securities).

Objectives

Moreover, both mutual and index funds typically have different objectives or end goals.

For index funds, the general objective is to match the returns of the benchmark (or underlying) index before fees. So, essentially, the objective of the index fund is to generate the same amount of returns as the benchmark index minus the fees. However, mutual funds generally aim to beat the returns of a comparable or related benchmark index after fees. Still, as a caveat, if the market is volatile (which is certainly the case currently), index funds may be harder to pull your funds out of on a moment's notice given the "advance notice" requirement index funds have.

Still, the objective of an index fund (to match returns) allows funds to keep fees and other costs low, leading to the next difference.  

Cost

What are index funds or mutual funds going to cost you?

As mentioned earlier, mutual funds will tend to cost you more in fees (expense ratio), with fees ranging from around 1% to upward of 3%. On the other hand, index funds are generally lower cost, with annual fees ranging as low as 0.05% to 0.07% (although some may be slightly higher).

For this reason, many investors cite the low fees as a major pull of index funds over mutual funds.

b) Advantages and Disadvantages of Index Funds?

Advantages

There are also a number of advantages to index funds. The main advantage is, since they merely track stock indexes, since they simply track stock records, they are latently overseen. The expenses on these index funds are low on the grounds that there is no dynamic administration. This can spare speculators a ton of cash through the span of their lives since less of their venture gains go toward charges and costs.

Scholarly examinations have indicated index funds beat dynamic administration assets after some time. Indeed, even a supervisor who reliably beats the market can show decreasing execution. In this way, it frequently bodes well for some financial specialists to incorporate index funds as a segment of their portfolios.

1. Advantage: Low Risk and Steady Growth

A central advantage to index funds is that they are generally okay alternatives for putting resources into stocks and bonds, intended for consistent, long haul development. They are characteristically expanded, speaking to a wide range of parts inside a index, which secures against profound misfortunes. Additionally, index funds often perform better than the majority of non-index funds that strive to beat the market. For instance, U.S. News & World Report noted in 2011 that index funds tied to the Standard & Poor's 500 index generated better returns over the previous three years than almost two-thirds of large-cap actively managed mutual funds.

2. Advantage: Low Fees

Index funds offer lower fees for investors than non-index funds. This means that even when a non-index fund outperforms index funds, it must perform better by a certain margin to generate returns that overcome the fees that it charges. One reason for the higher fees is that funds that are actively managed tend to have many more transactions than index funds, which are more passively traded because they stick to an index. And funds' transaction fees can accumulate.

Disadvantages

There are also disadvantages to using index funds for investments. A major drawback is the lack of flexibility in an index fund. Stock indexes had a great deal of volatility in 2008 and 2009. The index fund merely followed the stock indexes to the downside. However, a good active manager may have been able to limit the impact of the downside volatility by hedging the portfolio or moving positions to cash. Further, index funds can only provide average results at best. There is no opportunity to outperform the market and make massive gains. There is an opportunity cost to using index funds.

1. Disadvantage: Lack of Flexibility

Because index fund managers must follow policies and strategies that require them to attempt to perform in lockstep with an index, they enjoy less flexibility than managed funds. Investment decisions on index funds must be made within the constraints of matching index returns. For instance, if the returns in an index are declining strongly, index fund managers have few options in an attempt to limit those losses. In contrast, managers of an actively managed fund have more flexibility to act to find better-performing options in good times or in bad.

2. Disadvantage: No Big Gains

An index fund does not carry the potential to outpace the market the way that managed funds can. This means that if you invest in an index fund you are surrendering the possibility of a massive gain. The top-performing non-index funds in a given year perform better than the top-performing index funds, and the very best non-index funds can perform far better than an index fund in a year. However, the top-performing non-index funds may vary from year to year, so that under-performing years can cancel out the over-performing ones, while index funds' performance remains more steady.

c) To what type of Investor would an Index Fund be most attractive?

Investor interest in index funds is growing. The main reason for this is the changing return profile of large-cap funds. Most large-cap funds have failed miserably over the past year in the face of stiff competition. However, the majority among those that have gained in this category are index funds—either open-ended or the exchange traded funds (ETF).

The falling expense ratio of index funds have also made them attractive. The expense ratio of several regular plans of index funds are as low as 20 bps to 30 bps. For direct plans, it is even lower. The emergence of more independent fee-based Sebi registered investment advisers (RIA) is yet another reason. Since they don’t receive any commissions, these RIAs have been recommending low-cost index funds to investors. Continued contribution by the Employees Provident Fund Organisation (EPFO) have also boosted the growth of index funds, with the total asset under management crossing the Rs 1 lakh crore mark.

Low expenses make index funds attractive. In a developing market like India, where the returns from the equity markets have been outperforming all other asset classes in the last three-four years, the holding period of index funds has been lower than any other mature market. Most analysts believe that generally index fund’s investment should be from a long term view and the investors need to stay invested to even out the tracking error’s effect.

“Equity investments need to typically have an investment horizon of three-five years, be it through an index fund or an actively-managed equity fund,” advises Sivasubramanian K N, senior portfolio manager, equity, Franklin Templeton Investments (India). He believes that index funds are ideal for investors who prefer to take only market risk and not a fund manager risk and there is no set formula for index fund exposure and such funds could become popular once Indian markets become more efficient.

With that in mind, the best index funds for long-term investors include:

Fidelity ZERO Large Cap Index Fund.

There are a few attractive features of the Fidelity ZERO Large Cap Index Fund.

First, as the name would imply, it tracks high quality, large cap stocks, such as Apple, Microsoft (MSFT), Facebook, Berkshire Hathaway and Visa. These stocks tend to be more stable and less risky than mid-cap and small-cap stocks.

Vanguard S&P 500 ETF (VOO)

The gold standard of index funds is often considered to be the Vanguard S&P 500 ETF. The Vanguard S&P 500 index fund has been around forever. Its inception was back in 2010. Since then, the fund has developed a solid track record of delivering 13.4% total returns per year. That’s very impressive.

Schwab Total Stock Market Index Fund (SWTSX)

For investors looking for broader exposure to the stock market beyond just large-cap stocks, the Schwab Total Stock Market Index Fund is a solid choice.

It’s important to remember that the S&P 500 is just a collection of America’s 500 biggest companies. But, the total U.S. stock market has thousands of stocks. So, by buying an index fund that tracks the S&P 500, you are actually only getting exposure to a fraction of the total market.