Indexing is an investment approach that seeks to track the performance of a specific benchmark, or index. Index funds do this by holding all (or a sample) of the securities in the index being tracked. This “passive” investment approach emphasizes broad diversification, limited trading of the securities held in the portfolio, and low costs. The emphasis of indexing is on broad areas of the market and not individual securities.
THE BENEFITS OF INDEXING
Diversification
Maintaining a well-diversified portfolio is an essential part of a solid investment plan. Indexing can be an ideal way to achieve diversification. It’s difficult for actively managed funds to compete with index funds when it comes to diversification because index funds generally hold most or all of the securities in their target indexes. An actively managed fund typically holds a much smaller selection of securities that the fund manager believes will outperform its benchmark index. Although the diversification that index funds offer can’t protect you against broad market declines, it can reduce the risk posed by a dramatic decline in any one security or economic area.
Low Costs
Index funds have a return advantage from the beginning compared to actively managed fund and that is much lower costs. There are two main reasons that indexing costs less:
• Lower management fees: It costs less to manage and operate an index fund. That’s because index funds don’t have to employ highly paid fund managers and their staffs to analyze and select stocks.
• Lower transaction costs: Index funds use a fundamental buy-and-hold approach, which means that index fund managers generally turn their portfolios over far less often than active fund managers. This reduces the brokerage, commission, and other expenses associated with trading securities, and results in lower trading costs. You get to keep more of your money when using index funds.
Competitive Performance
Thanks to their diversification and low costs, index funds can be an effective way to achieve competitive returns over the long run. Depending on the asset class, various studies have shown 80% to 90% of index funds beat actively managed mutual funds in a given year.
Potential Tax-Efficiency
As noted earlier, index funds typically have much lower portfolio turnover than actively managed funds. Therefore, most index funds tend to realize and distribute only modest capital gains. This is particularly important if you hold index funds in taxable accounts.
Simplicity
The investments inside of an index fund are transparent and easy to compare. They have a precise, easily understood objective—to track the performance of a specific index. With index funds, you always know how your money is invested.
What are the risks?
