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Index Tracking Funds – The Fund That “Smiles Back”

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Introduction

 

 

Funds that track a market index, such as the S&P 500, are known as index funds. Index funds include both index mutual funds and index exchange-traded funds, or ETFs. These funds typically use a passive investing strategy, which means their objective is to deliver returns similar to an index of investments.

However, index funds usually deliver returns that are slightly lower than an index due to fees associated with these funds.

In this lesson, we’ll discuss how index tracking funds work, identify some of the indices these funds track, and examine benefits and risks associated with this type of fund.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Index Funds

 

 

Simply put, index funds are built to have a similar performance to that of a major market index. This
means they tend to be diversified in securities across that index and include a number of investments.

There are many market indices and index funds that follow them.

For example, if you want to invest in US stocks, you might invest a fund that tracks an index like the….

 

  1. S&P 500 – which follows the 500 largest stocks in the market
  2. Dow Jones Industrial Average – which includes 30 large-cap industrial stocks
  3. NASDAQ-100 – which follows 100 large-cap technology stocks….or
  4. Russell 2000 – which tracks 2000 small-cap stocks

For international stocks, an example of a widely tracked index is the MSCI EAFE, which includes large-cap stocks in developed countries across Europe, Australia, and the Far East (hence the acronym EAFE. And in case you were wondering, MSCI stands for Morgan Stanley Capital International).

For US bonds, an example of a widely tracked index is the Barclays Capital Aggregate Bond Index, which includes a mix of government bonds, mortgage-backed securities, and corporate bonds with different maturities.

As you can see in these examples, index funds can track different assets, including stocks and bonds. There are even index funds that follow commodities, currencies, and other assets.

But regardless of which type of asset they track, an index fund still has its risks.

Benefits & Risks Of Index Funds

 

Put simply, index funds are exposed to the same risks as the index they’re following.

For instance, if the S&P 500 declines in value, then the index funds which track it will follow suit.

 

 

An index that tracks bonds is at risk if interest rates rise and bonds decline in value.

 

 

Some investors are willing to accept these risks, and choose to invest in index funds because of the potential benefits they might offer.

A primary benefit is the typically lower expense ratio, which is the ongoing cost of investing in the fund compared to actively managed funds.

As the name implies, actively managed funds use an active investing strategy. This means that they frequently buy and sell investments. This typically results in higher costs or expense ratios and can be a drag on a portfolio’s performance over time.

Because index funds are passively managed and simply track an index, they generally have a low portfolio turnover, which means they infrequently buy and sell investments.

Infrequent buying and selling typically translates into low expense ratios. The low expense ratios of index funds can possibly lead to more growth when compared to the higher expense ratios of similar actively managed funds.

Let’s look at an example.

Suppose an investor purchases $50,000 of two funds that both grow 7% per year, before expenses, over the next 30 years. The funds are similar in all respects – except for the expense ratio.

Fund A is an actively managed fund with an expense ratio of 1.2% – and in the next 30 years, this fund would grow to $271,356.

Fund B is an index fund with an expense ratio of 0.2% – and in the next 30 years, this fund would grow to $359,838. That’s a difference of $88,482, and its all thanks to a low expense ratio.

To clarify any confusion as to how I received these calculations – you would have to use the compound interest formula – as this is how most investors predict the theoretical value of their investment over a set time period.

 

 

Fund A has a principal (P) of $50k, a rate of return (r) of 5.8% after taxes, commissions, and fees, compounded annually (n=1), and you want to find the growth of the account after 30 years (t). Simply plug it into the formula and this will give you the theoretical value of your portfolio – approximately $271,356.

Fund B, on the other hand, has a rate of return (r) of 6.8% after taxes, commissions, and fees – which is far greater than that of the first fund. Using the previous data as constant variables, you will receive a theoretical value of $359,838 – allowing you to achieve a greater return.

The low cost of passively managed index funds can make a difference and is a reason index funds may outperform actively managed funds over long time periods.

This is why some investors take the “if you can’t beat ’em, join ’em” approach and use index funds to simply track market indices.

 

 

Quick Recap

In Review….

Investing In Index Funds

 

  • Simply put, index funds are built to have a similar performance to that of a major market index. This means they tend to be diversified in securities across that index and include a number of investments
  • Put simply, index funds are exposed to the same risks as the index they’re following
  • For instance, if the S&P 500 declines in value, then the index funds which track it will follow suit
  • An index that tracks bonds is at risk if interest rates rise and bonds decline in value
  • Some investors are willing to accept these risks, and choose to invest in index funds because of the potential benefits they might offer
  • A primary benefit is the typically lower expense ratio, which is the ongoing cost of investing in the fund compared to actively managed funds
  • Because index funds are passively managed and simply track an index, they generally have a low portfolio turnover, which means they infrequently buy and sell investments
  • Infrequent buying and selling typically translates into low expense ratios. The low expense ratios of index funds can possibly lead to more growth when compared to the higher expense ratios of similar actively managed funds
  • The low cost of passively managed index funds can make a difference and is a reason index funds may outperform actively managed funds over long time periods

 

Common Types Of Index Tracking Funds

 

  1. S&P 500 – which follows the 500 largest stocks in the market
  2. Dow Jones Industrial Average – which includes 30 large-cap industrial stocks
  3. NASDAQ-100 – which follows 100 large-cap technology stocks
  4. Russell 2000 – which tracks 2000 small-cap stocks
  5. MSCI EAFE – which includes large-cap stocks in developed countries across Europe, Australia, and the Far East
  6. Barclays Capital Aggregate Bond Index – which includes a mix of government bonds, mortgage-backed securities, and corporate bonds with different maturities

 

And this is the basis of index-tracking funds. The explanation is quite self-explanatory, as it consists of the same characteristics as other mutual funds – but track an index instead.

Since these funds track an index (instead of an individual asset or market sector), they are considered to be a conservative and safe investment – but they’re not invincible and are still prone to risk if the assets within the index itself tanks – making the fund tank simultaneously.

Index funds are managed passively, which will result in a lower expense ratio, saving you the ongoing costs of commissions and fees in the long term. When choosing between index funds, you will need to access your risk tolerance, time horizon, and if the costs and fees that come with the fund will meet your investing needs and goals.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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