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Index Funds: What are they, and should you invest in them

Updated on April 18, 2013

Index funds….ok, so your 401k has them and your buddy at work tells you to invest in them, but what are they? And should you invest in them? In this article, I wil explain what they are, and how you could benefit by investing in index funds.

An index fund is a mutual fond or exchange traded fund (ETF) that that aims to replicate the movement of an index of a specific financial market. For example, anindex fund may follow the S&P 500 or the Nikkei 225. Or it may follow the index of a specific sector or purpose, such as emerging markets or large cap stocks. This index is followed reguardless of market conditions.

There are various ways that an index fund may follow an index. It may be invested in all of the securities of a particular index, in the same proportions as the index. Another method is to statistically sample the index and invest in securities that are “representative” of that index. Computer modeling may be used to come up with the representative securities, thus buying and selling securities with little or no human interaction. Because of this, fees tend to be low.

Advantages of Index Funds

Index funds have Low Costs

Because they follow a specific set of investment principals, index funds have no need for highly paid stock pickers or analysts. And since there tends to be less trading than an activly managed fund, fewer transaction fees are passed on. For example, the average expense ratio for an actively managed large cap fund is 1.36%, while for a large cap index fund the average is 0.15%.

Long Term growth and stability

Individual stocks can fluctuate in value a great deal. However, since index funds are tied to the performance of the market, their fluctuation over the long term is reletively low. (And by long term, I’m talking decades.) Over the span of decades, these funds tend to produce consistant, low to mid range growth. You won’t get rich, but you will earn respectable returns over the long haul.

Minimum amount of time to manage

Lets face it, most people do not have the time to put in hours every week to manage their investments. By choosing an index fund, much less research is needed. This is not to say that you should not do your homework on a paticular fund (more on this later), but much of the work has been done already.

Reduced Capital gains distributions

By their very nature, index funds do much less buying and selling of stocks. This results in less capital gains tax passed along to those invested in the index fund. Additionally, when index funds do sell stocks, it is generally after holding the stock for a long time, so the gain is taxed at the lower long term capital gains rate.

What to watch for

Expense Ratio

While index funds tend to have low expense ratios, it is important to compare the expense ratios of different funds. Fund expense ratios can varry greatly, so always check up on this.

How well does the index match the performance of the market?

That low expense ratio doesn’t do you any good if the fund trails way behind the market. Look at how the fund has performed in the past, and look at its long term trends. Compare it to other funds that follow the same index.

So are index funds for you? To be safe, alway seek the advice of a good financial planner before making an investment. Personally, I love these funds for long term investments. The low expense ratios are great, and I like the fact that when capital gains are passed along to me, they are passed on at the long term rate. If your 401k or IRA has index funds as an option, they are definately worth the time to check out.

Thanks for reading. I hope you have enjoyed this hub!

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