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Index Funds

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Index funds passively invests only in shares that are within a specific index tracked by the fund. They’re also known as passive funds. Index Funds do not trade based on a manager’s predictions of the market. Instead, a passive fund attempts to hold the exact same ratios of each investment on an index or exchange. If an exchange adds a company to the index, or a firm’s share fits requirements for inclusion in the fund, index funds will add their stock to their holdings. It will be added to the exact proportion it has on the exchange.

It may not hold every single investment in an index. If an index fund’s requirement is that shares be within the top 400 capitalizations to be included in an index fund, management will buy the 401st largest capitalization to the fund only if it replaces the current 400th. Management would sell the shares from the index fund that no longer fit within the top 400. These would be the only time that an index fund trades shares. For larger index funds, they would buy shares after an initial public offering and sell shares when they are delisted from the index or exchange.

Since Index funds track an index, benchmark, exchange, or classification, they can only ideally do as well as their benchmark index performs. If the index or benchmark rises, the index will rise. If the benchmark falls, the index will also fall. The fund’s objective is to do no better, and no worse than its emulation target. It should never be the best performer or the worst performer. It should be constantly on par with the index’s performance. Index funds will never be the best in the market, since they can’t be by design. But since they are on par, they will outperform many funds which fail to beat the market. In any given time period, between 60% and 80% of actively managed funds will fail to beat the market. This is due to cost, bad research, analytical error, or poor estimations. Many of the actively managed funds which do beat the market do so by less than 1%. While index funds won’t ever win the 1st place spot, they will beat a vast majority of actively managed firms which fail to beat the index performance.

Active Funds Versus Index Funds: Costs

Active funds have higher costs than index funds. They require research and tracking, while index funds simply match an existing index. Active funds must purchase research, set up news feeds, purchase price tracking systems, and pay traveling expenses to review the investment quality. They pay researchers and analysts to check and recommend investments. Active funds also pay trading fees far more often, since index funds simply hold a portfolio. Those expenses stack over the long term, resulting in active funds being far more expensive to operate than index funds. Active funds face a performance hurdle due to these fees, since costs reduce returns. To beat the market, actively managed funds must create performance that equals cost to break even, and then exceed the market returns. This is unlikely, which is why so many lag behind their indexes.

Index funds excel at low costs and fees. Over the long term, that alone is enough to defeat the vast majority of actively managed funds. Index funds do not have to constantly research, travel to investigate potential investments, or make use of analysts and researchers. They also do not have to constantly trade shares, incurring trading commissions. Low turnover equates to low amounts of trading expenses. They simply create the index portfolio and hold it. They only make minor adjustments to the overall index fund. They save money on all of these costs. Since they have lower overall expenses, they also charge less in fees and commissions. They can charge substantially less than active funds, ranging from 25% to 50% less in fees. This reduced expense means you keep more of your fund’s returns, which increases the chances your index fund will exceed your active funds in returns.

Lastly, both Index funds and Active funds exist with specializations. Some funds will invest in growth shares only, others in value shares. You can find specializations for both funds in specific markets, industries, or nations. Both equity and bond markets can be indexed.

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