Investors in the country have started paying attention to index funds as they are realizing that these funds could be an effective, low-cost, and convenient way to build wealth over the long term. While most people think of actively managed mutual funds when they think of investing in mutual funds, understanding how index funds work and their pros and cons can help you make a more strategic investment decision.
Pros of investing in index funds
- Lower costs
One of the biggest benefits of index funds is that they have lower costs than actively managed mutual funds. Since index funds track a benchmark index and follow a passive investment management strategy, the role of the fund manager as analysts and other experts is low. In addition to that, the trading activity is also not as high or frequent unless there is a change in the composition of the benchmark index. So, the transaction costs and fees are also lower. The fund houses tend to pass on these benefits to investors in the form of lower expenses ratios.
- Broad-based diversification
Since stock market indices are constructed in a way to capture the broader market instead of a niche segment or a single investment, index funds also offer broad-based diversification. Most broad-based indices include a large group of stocks picked in a way that they represent the overall market trends and sentiments. So, when you invest in index funds, you are essentially investing in the market as a whole and the long term, this will be beneficial as the broader market will always outperform a single investment.
- Eliminates manager risk
Every mutual fund comes with a fund manager who is an expert that manages the fund’s portfolio. The fund manager has the responsibility of making all the important investment decisions such as when to buy, sell, and hold the underlying securities in a way that maximizes the returns for the investors. The downside to this is that a bias or bad decision on the part of the fund manager can make your returns take a hit. However, in index funds, this is not a problem as the fund is mimicking the benchmark index and moves in tandem with it. So, the manager’s performance or expertise is not a concern with index funds.
Cons of investing in index funds
- Tracking error
While index funds are designed in a way to closely track and replicate their benchmark index and generate the same type of returns for their investors, in reality, they may not always be able to do this very closely. The difference between the index fund and its benchmark’s performance is called the tracking error. This is why when looking at index funds to invest in, look for funds with the lowest tracking error.
- Set strategy
The downside of index funds being passively managed means that they offer limited exposure to different investing strategies. Neither the fund manager nor you as an individual investor can make use of different strategies to maximize returns based on the market conditions. In some cases, a smaller, more targeted portfolio may generate higher returns, but most index funds will continue being broad-based.
The bottom line
Before you invest in index funds, you should look at a few key factors that determine your overall investment strategy. These include your financial goals and risk tolerance. The index funds’ risk-return profile must align with your goals and risk appetite. For this, also make sure to consider the current asset allocation of your investment portfolio.