The index fund is the term used in the context of stock markets; it is that type of mutual fund which mimics the performance of an index by investing money into stocks according to their weightage on an index. Hence for example, if there is an index fund which mimics the performance of NASDAQ and if the weightage of Microsoft stock in NASDAQ is 3 percent and Google stock is 4 percent than index fund will invest 3 percent of the total portfolio of mutual fund in Microsoft and 4 percent of the total portfolio in Google and so on. In order to have a clear understanding of this term, one should look at the advantages and disadvantages of index funds –
Advantages of Index Funds
Lower Risk
The biggest advantage of index funds is that the risk is lower in such funds because these funds invest money according to weightage of stocks on the index and hence there is no risk of fund manager investing a substantial amount in low-quality stocks resulting in the loss to the investors even when markets are performing well.
No Bias of Fund Manager
In case of actively managed funds fund manager select stocks according to their bias even if it results in loss to the investor but as far as index funds are concerned there is no chance of personal bias of fund manager creeping in as these funds invest money according to the weightage of the stocks in the selected index.
Lower Fees
Actively managed fund involves costs as fund managers constantly reshuffles the fund by buying and selling stocks according to price and other factors, since buying and selling involves costs it results in higher fees from investors which is not the case with index funds where investor will have to pay lower fees as there is less reshuffling of stocks in these funds.
Disadvantages of Index Funds
Not Flexible
The biggest disadvantage of an index fund is that it is not flexible implying that fund managers cannot change the weightage of stocks in the fund according to market sentiments rather they have to stick to the weightage of the index even if it implies lower returns for the investors. In simple words in these funds, the hands of fund managers are tied and we all know that with hands tied one cannot give his or her best no matter how much talent one has.
Lower Return
Another limitation of these funds is that since fund managers are not allowed to have their say and experience these funds generate a lower rate of return because the index cannot grow 15 or 20 percent annually which is the case with midcap and small cap stocks which can give good annualized returns for a long period of time
Over Diversified
Diversification in case of stock markets happens when one invest money into several sectors so that risk of one sector is offset by other sector but when one replicates the whole index than it will result in over diversification as index is made of all sectors and one or two sectors will always be in trouble resulting in negating the positive return earned from other sectors. In simple words, over-diversification is one of the reasons for index funds giving lower returns than other funds.
As one can see from the pros and cons of index fund it is not an easy decision for an investor and that is the reason why an investor should carefully read above points and then decided whether he or she wants to put money into index funds so as to get the desired return or is there any other better alternative.