How do they work?

Most of them work like your usual mutual funds; each fund has a price – Net Asset Value – and is traded on a daily basis. They also charge for management fees, trading costs, and may distribute dividends and/or capital gains.

How are they different?

They are considered passive as their manager simply follow the index as closely as possible; they do not try to cherry pick the stocks they hold like usual mutual funds. They do not need to have battalions of analyst to uncover potential hidden gem on the stock markets. Many index funds have little or no human input in the decision thanks to the index they are tracking and the use of computer model to follow them.

What does this means for you?

Firstly, this means that you exactly know what you are investing in when chosing such funds. They are very diversified, and are a very good base to build a portfolio upon as their diversification is very good.

Secondly, your trading costs should be much reduced thanks to low stocks turnover – Indexes do not change on a regular basis, and their components are stable. Striking two birds with one stone, this will also helps avoid capital gains taxes. Their low turnover means that the fund will less frequently need to sell stock to accommodate index changes, saving you the trouble of dealing with these tax liabilities.

Thirdly, thanks to their little human input, the management fees are much reduced – the manager’s job being much simplified. As an example, the Vanguard S&P 500 has a very expensive ratio of 0.1%. You can’t really beat that.

These cost savings can be quite substantial. You can sometimes saves as much as 3 to 5 percent in return per year when comparing with some actively managed funds. Of course you may not have the pleasure to brag about how your portfolio beat the indexes. But you are sure not to have to see your nice double digit returns being eaten up by expensive fees.

Sounds great – but what are the caveats?

Of course, you guessed from the hereabove that I quite like index funds. While I think they are great, you may encounter potential hiccups. What could they be?

First, you will certainly not outperform the market as the funds try to match them. Some discrepancies may happen, but they usually are because of errors in tracking – our second point.

Secondly, some funds don’t track their index as perfectly as you would wish they do. They may take a little time to match changes in their index, or their cash position is sufficient to tamper their performance.

Thirdly, even though indexes are pretty stable, their composition changes over time. As an example a company like Google was not indexed only a few years back. The S&P 500 index has a typical turnover of between 1% and 9% per year. In effect, the fund manager will have to sell its position in markets that fell out of the index and buy the replacing ones so as match the new index.

Finally, following indexes means that you will also enjoy the ups and downs of the tracked index. You will therefore not be fully protected when global market go south. But your diversified investment is a great way to dilute your risks.

At the end of the day…

As said earlier, index funds are great tools to build a portfolio upon. The success of the Vanguard S&P 500 index fund is an example of the investors love for such product. This fund is present in so many investor’s portfolio that it has even more assets under management than Fidelity’s massive Magellan Fund. Quite a statement !

Picking the right fund can be difficult, especially when you are no specialist and are trying to get consistent returns. Even the best of managers know off-years. As a result of this, you are very likely to end up with an average performing fund, which may beat the market,but only by a thin margin. Furthermore, your average performance will suffer from the trading and management fees you will have to pay to the manager – there are few Berkshire Hathaway.

Many investors do not wish to take these risks, yet want to enjoy the profitable long term growth of the stock markets. They want to achieve diversification, so as to not put all their eggs in the same basket, seeing their profit being taken away by hefty management fees.

Such investors likes to base their portfolio on passively managed funds – indexed funds and exchanged traded funds. These type of funds enjoy very low management fees since they do not require any research — they simply monitor the index so as to mimic it. They also give investors an easy “15-minutes-do-it-yourself” diversification strategy.

I see such funds as base to build from a great portfolio. I so highly think of them that I decided to further introduce Index Funds and Exchanged Traded Funds in soon to come posts – a little teaser never hurts