Index funds tap into an important issue: whether investors should take an active or a passive approach. Like so much with investing, personal circumstances will determine the best approach for individuals. But index funds should come with lower fees than many other forms of investing – and this can have a big impact on long term returns.
Track the best benchmark
Index funds – or index trackers as they are sometimes called – are typically a portfolio of investments designed to track an established, weighted index. The portfolio might consist of a selection of individual company shares designed to match the performance of the DAX, EuroStoxx or other broad-based share market index. Alternatively, it could consist of bonds, property or commodities and be designed to track the performance of an index of these investments.
Be aware that one index is not necessarily the same as another. When considering share market indexes, for example, the Dow Jones index is constructed of different companies and in a different way to the S&P500 or the Russell2000. Each index could move in different ways, so make sure you know the characteristics of the index your fund is tracking.
Prefer to track property or bonds?
Perhaps because share trackers are so well-known, some people are unaware index funds can be made of property, bonds or other investment types. It is important to know of the different types of index funds because it can help with getting the right fit for your tolerance to financial risk. It allows investors to use funds in a lifecycle approach by reducing risk the closer they get to their investment goal.
Passive (and competitively priced)
Index funds are usually a way in which people follow a passive rather than active approach to investing. They might be used to build up long-term savings, such as in a pension fund. “Passive” investing aims only to match the performance of a targeted index while “active” investing relies on the decisions of an investor or fund manager, who typically tries to outperform the same index. There is debate about which approach is better.
Supporters of passive funds often question the ability of any particular active manager to consistently outperform their benchmark. The index funds used by passive investors also typically benefit from lower total costs (which may include an annual management charge and transaction fees for the buying and selling of shares and bonds) than funds used in active investment strategies. This is because passive investing typically involves fewer trading decisions and is much cheaper to run. Over long periods, even small differences in fees add up.
A study by academics Eugene Fama and Kenneth French found that once costs were taken into account, investors in active funds saw actual returns below those of an equivalent portfolio of passive funds.
EFTs – a new-ish option
Exchange traded funds (ETFs) have developed as another form of passive investing similar to index funds. ETFs, however, are traded in a manner similar to individual shares, meaning they can typically be bought and sold rapidly. ETFs are considered by some to be a substitute for index funds but fees, documentation and other aspects may vary.