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What are Index funds? How do they Work?

Introduction

The origins of the index fund can be traced back to the year 1960, when two students at the University of Chicago, Edward Renshaw and Paul Feldstein, suggested a theoretical method of establishing an index fund in their paper, calling the model 'Unmanaged Investment Company'. Their efforts were soon followed by others doing the same. The first Index fund was established on July 31, 1972, by a Florida based company called Qualidex Fund, Inc., which followed the performance of the Dow Jones Industrial Average. Index funds were popularised by the First Index Investment Trust, established by John Bogle in December 1975.

What are Index Funds?

  • Index funds are a form of an exchange-traded fund or mutual funds with a stock portfolio that attempt to emulate the performance of a particular index it uses as the benchmark.

  • Index funds are a form of passive fund management built around a portfolio that mimics the securities of a particular index, with the idea of emulating the performance of the said index.

  • Index funds only change their portfolios if the index itself has gone through a significant change or to balance the fund in case the fund follows a weighted index.

Additional Read: 7 reasons to invest in Mutual Funds

Advantages and Disadvantages of Index Funds

Advantages of Index Funds are as follows:

  • Index funds work on the principle of passive management resulting in a low expense ratio in management costs.

  • Index funds work by matching the performance of an index, which can lead to better long term returns due to their focus only on stable growth and not high-risk speculation.

  • Index funds are ideal for passive investors simply looking to buy and hold stocks for the long term.

  • Since an index fund attempts to mimic the performance of an index, it buys stocks from a broad segment of the economy, allowing for easy and high diversification.

Disadvantages of Index Funds are as follows:

  • Since an index fund follows an index closely and attempts to mimic its performance, index funds are vulnerable to market fluctuations and crashes.

  • Index funds lack flexibility, as investors can choose only that which enables the fund to mimic the index's performance.

  • Index funds require very little human oversight and are thus vulnerable to cyber attacks.

  • Index Funds have low returns, which are only feasible during a bull market or with a long-term investment plan.

Types of Index Funds

Index funds can be classified into the following subtypes:

  • General market index funds emulate a significant portion of the stock market and are generally the least expense intensive and the most tax-efficient.

  • Market capitalisation index funds structure their portfolios according to the market shares held by the companies in the portfolio.

  • International index funds mimic the performance of global indexes.

  • Earnings based index funds are based on the profits generated by companies.

  • Bond based index funds invest and mimic the performance of different types of bonds.

Additional Read:What are arbitrage mutual funds?

Conclusion

Index funds are an attractive form of investment due to their inherent low risk and relative stability. However, their low returns and vulnerability to market crashes can make them a risky proposition. Investors would be more secure investing in managed funds for short term gains, with investments in index funds better suited to long term financial requirements. Mixing investments would allow investors to circumvent the disadvantages of index funds.

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