Index funds or passively managed funds

Index Funds:

What are Index funds or passively managed funds?

Index funds, as the name suggests, invest in an index. These funds purchase all the stocks in the same proportion as in a particular index. The scheme will perform in tandem with the index it is tracking, save for a small difference known as tracking error.

Unlike actively managed mutual funds, index funds passively track the performance of a particular index. These funds are not meant to outperform the market, but mimic the performance of the index.

Index funds are popular in developed countries like US and are yet to get popular in developing countries like India, as there are number of companies growing more than index.

Index funds are a popular way to participate in the stock market and diversify a portfolio. Index funds have several major advantages over direct ownership of the underlying securities. Here’s a brief review:

Diversification — Each index fund represents an interest in an underlying basket of securities. This allows investors to gain broad exposure to a large group of companies easily. This diversification also makes index funds much less volatile than individual securities. Foreign index funds in particular make diversifying abroad less difficult and expensive; they also offer exposure to entire foreign markets and market segments.

Low Cost — Buying of an index and selling shares fund is far less expensive than separately buying and selling a basket of underlying shares. Also, the decision of which securities to invest in is determined by the index rather than by active management. This is why index funds usually have minimal expense ratios and are often more affordable than other diversified investment vehicles.

Liquidity — Index fund shares are bought and sold on major exchanges every day, and many funds trade hundreds of thousands (and in some cases millions) of shares per day. Buying and selling shares of an index fund can be faster and more convenient than buying and selling the underlying shares.

Dividends — Many index funds pass through the accumulated dividends paid by their underlying stocks. Over time, these dividends can add up to a significant sum.

Returns — Studies have proven that over time, the average mutual fund typically fails to beat the broad indexes. With this in mind, index funds are a great way to capture broader-market returns. For adherents to the efficient market hypothesis, which states that it is impossible to outperform the broad stock market over the long haul, index funds can be a way to optimize portfolio returns.