What are Index Funds?
Index funds are mutual funds or exchange-traded funds (ETFs) that are designed to track the performance of a market index. Currently available funds track different market indices, including the S&P 500, Russell 2000, and FTSE 100.
An index fund is a form of passive investment. This means that portfolio managers do not need to spend a lot of time and resources on choosing suitable stocks for investments or rebalancing the portfolio. On average, the portfolio is rebalanced once every six months. Few operational and administrative requirements mean cost efficiency for such funds.
Generally, these funds are considered safe and simple long-term investments. Thus, they are actively used in retirement plans.
Index Funds vs. Actively Managed Funds
Index funds are a viable alternative to actively managed funds. Index and actively managed funds can be compared according to the following parameters:
While index funds may seem like an unsophisticated means of investing, they tend to outperform their actively managed counterparts. Statistics show that more than 90% of actively managed funds not only cannot beat the market but perform worse than the market benchmarks. However, this is not always the case, since hedge funds perform better in down markets.
Index funds are less costly to the investors relative to actively managed funds. The expense ratio (the annual fee that a fund charges its investors for administrative and operating expenses) usually does not exceed 0.1%. On the other hand, actively managed funds may ask for expense ratios up to 0.7%. However, an investor should still pick the type of investment fund based on his/her investment style and goals.
Index-based funds work best if an investor needs a safe and diversified investment with almost a guaranteed return over a long investment horizon. Also, they are suitable for unsophisticated investors who do not wish to invest time or money in extensive investment research.
Actively managed funds provide an investor with the opportunity to beat the market. The funds may deliver a greater return over a short investment horizon. Investors in such funds should possess some investment experience and knowledge to be able to understand the strategy employed by the fund.
CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)™ designation for financial analysts. From here, we recommend continuing to build out your knowledge and understanding of more corporate finance topics such as: