What are Index Funds?
An index fund is a form of a passive fund management. It 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 in six months. Few operational and administrative requirements result in the cost efficiency of the index funds.
Generally, index funds are considered safe and simple long-term investments. Thus, they are actively used in the retirement plans.
Index Funds vs. Actively Managed Funds
Index funds are a viable alternative to actively managed funds such as mutual funds and hedge funds. Index and actively managed funds can be compared according to the following parameters:
While index funds may seem as an unsophisticated means of investing, they tend to outperform its 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, it is not always the case since hedge funds perform better in down markets.
Index funds are less costly to the investors relative to mutual or hedge funds. The expense ratio (the annual fee that a fund charges its investors for administrative and operating expenses) for the funds usually do not exceed 0.1%. On the other hand, actively managed funds may ask for expense ratios up to 0.7%.
From the facts above, it seems index funds are better than mutual or hedge funds. However, an investor should pick the type of investment fund based on his/her investment style and goals.
Index funds work the 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 are not willing to figure out the complicated theory behind the investments.
Mutual and hedge funds provide an investor with the opportunity to beat the market. The funds may deliver a greater return over a short investment horizon, but an investor 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: