For investors looking to diversify their portfolio, index funds are one of the most popular options. These funds track the performance of a particular market index – which can be as broad as the S&P 500, or as narrow as small-cap biotech companies. The basic advantage of an index fund is it allows investors to put their money into a particular sector, without having the risk of exposure to any one company. They are also relatively uncomplicated – the fund manager automatically adjusts the underlying investment portfolio to track the index, so individual investors can be relatively hands-off.
Another key advantage of an index fund is that the management fees associated with them are extremely low compared to a typical mutual fund. In many cases, the charges are 0.1% or lower, compared to an actively managed fund, where the fund manager can take a cut of 1.5% or even more. However, before you invest in an index fund, it pays to check how much it costs – there are some index funds out there that charge exorbitant fees, despite the fact that next to no effort goes into managing the fund.
Another thing that is important to understand is that index funds are not designed for trading indices – as in day trading. Buying and selling index funds through a brokerage typically involves a high commission – in fact, index funds want investors to hold a long-term position since their goal is to have a stable pot of money invested in the fund. If you do want to trade on a regular basis, then you may be better to invest in exchange-traded funds (ETFs). These behave in many ways like an index fund – but they are actively traded on stock exchanges and usually carry much lower commissions.
Any experienced investor will tell you that diversification is key to making sustainable profits – take a look at Scott Reiman SlideShare data. However, it is a mistake to assume that investing in a single index fund will provide the level of diversification that you need. All an index fund does is give you exposure to a particular market segment – it is no substitute for properly planning your asset allocation. To start with, individual indices in a single geographic market such as the United States perform differently – each one tracks the underlying dynamics of that market sector, be it large-cap firms on the Dow Jones, or small-cap energy stocks. Furthermore, there is typically no geographic component – if part of your strategy is to leverage growth in emerging economies, you’re not going to get this by tracking the S&P 500. Finally, true diversification involves investing in a number of asset classes – stocks, bonds, commodities, and so on. You do not get this level of diversification with a single index fund.
Overall, index funds are a good vehicle for novice investors who want to tap into market growth in a relatively low-risk fashion. They are also well suited for experienced investors who want to pursue a long-term investment strategy – provided that they diversify across funds and into other asset classes.