Important Points

  • An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index.
  • Index funds have lower expenses and fees than actively managed funds.
  • Index funds follow a passive investment strategy.
  • Index funds seek to match the risk and return of the market, on the theory that in the long-term, the market will outperform any single investment.

What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes and index funds such as BlackRock or Vanguard. Vanguard Total Stock Market Index (VTSMX): Vanguard is the original indexer, and VTSMX is among the first index funds to capture the total market.

Advantages of Index Fund

  1. Very Low Fees: They have low management fees than any other funds since it is passively managed. Instead of a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index.

2. Lower Tax Exposure: Many lots of securities are bought whenever an investor is investing their money, so there are many lots to choose from when selling a particular security. This means they can sell securities for low capital gains and therefore, low tax ratio.

3. Passive Management :

Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in the returns, especially over the long haul.

4. Broad Diversification: Most index funds are diversified, this means they invest in a large number of securities. Broad market index funds offer greater diversity, meaning that they invest in a larger number of securities than less broad index funds.

Disadvantages of Index Fund

  1. Not Actively Managed: Since the funds are not actively managed which means no adjustments or rebalancing takes place for a better performance. The fund is only managed when the index being tracked adds or removes a stock or investment which means it all depends on the market and if there is a volatile market or crash then the funds performance may result on losses.

2. Can Underperform: This is one of the disadvantages of Index Funds, they can underperform since it is not actively managed unlike large index funds which are actively managed. So, when an investor is investing their money in the index funds, the money might not grow for a long time by placing it in better funds and securities.

3. No Flexibility: There are strict rules for index funds investing, index fund is an all-or-nothing proposition. One cannot choose, include or exclude different stocks. An Investor cannot invest more in one part of the fund than in another part so they are investing in the entire fund as it sits.

4. Over Focused: It can be over focused which means it tracks a small niche or one part of the market, so there is a lack of diversity.