What Is An Index Fund?

I f you have ever opened your computer and searched “what is an index fund,” you may have gotten a lot of information that is not quite easy to understand. In this article, we explain to you in simple terms what an index fund is and what it means to invest in one.

What Is an Index Fund?

An index fund is a passive form of mutual fund which purchases stocks from a certain market index that are similar. They follow a particular benchmark index, for example, the Nasdaq 100 or S&P 500.

An index fund is not any safer than other forms of investment, however, most index funds (especially the most famous ones) often outperform themselves. When you select a certain index fund to invest in, make sure you research previous years and the annual profit margin. If you are aiming for long-term investment, index funds may prove to be a good option.

How an Index Fund Works

To understand how investing and profit-making work regarding index funds, it is important to understand what an index actually is. A group of multiple securities from a certain market segment is known as an index.

Index funds track this particular index per its benchmark, and that is how the securities are traded. This is why an index fund is a passively traded fund. The performance of the index is usually parallel to that of the benchmark, with a slight error sometimes. This is known as a “tracking error” and the manager of the fund aims to reduce this error as much as they can.

Mutual Fund vs. Index Fund

If you’re someone who knows a bit about investing but is unclear on the details, you may end up confusing mutual funds for index funds. While at first glance they do seem similar with multiple similarities, the main distinguishing difference is that the securities remain the same in an index fund while they routinely change in a mutual fund.

The manager of an index fund is given a setlist to invest in, which for example may be the Fortune 500 or any other group. Mutual fund managers, however, change the list of securities as they see fit, selecting opportunities that they feel may yield more profit.

Furthermore, mutual funds aim to perform higher than the market average, while index funds aim to simply touch the same pre-set benchmark, leading to index funds having a predictable outcome. Since this requires managing mutual funds differently and more efficiently, mutual funds have higher fees too.

Benefits of Investing in an Index Fund

Now that you know what an index fund is, let us tell you why you should select them as a viable investment option.

Low Fees

One of the best parts about index funds is that analytical research is not necessary for them to be successful. Index funds mimic the underlying benchmark, therefore selecting the “right stocks” is not a thing to worry about. Secondly, index funds are passive, so there’s no active trading. These factors reduce managerial costs, which leads to low fees.

Zero Bias Investing

Investing in an index fund is automated, therefore there is no subjectivity. The method is regulated, and as such, the fund manager is given a set amount to invest in multiple securities across a wide range of sectors. This resolves any personal bias when it comes to making decisions.

Market Exposure is Broad

Index funds allow the portfolio to include several different stocks and sectors, leading to a lot of diversity. As such, through just a single fund, investors can receive returns from a larger portion of the market, including sectors such as pharmaceuticals and medicine to automobiles and oil.

Tax Benefits

As explained earlier, index funds are managed passively, which has a lot of benefits, such as a low turnover. This is because annually, fewer trades are administered by the manager of the fund, and as such, lesser capital profit distributions get passed on to unitholders.

Not Difficult to Manage

Investing sounds overwhelming, and this is why a lot of people who have a sufficient amount of funds often do not invest their money. However, index funds are comparatively easier to manage, because managers don’t have to be worried about how stocks are doing within the market. All that needs to be done is for the portfolio to be periodically rebalanced such that everything is in order.

Now that you know the answer to “what is an index fund,” you should consider investing your money in them!