They’re boring and passive. They are run on autopilot by hands off managers. Instead of making decisions about the best course of action, the managers merely try to match the overall market’s performance. They strive to be average. But an investing strategy built on these funds will soon bring higher returns than chasing after the best actively managed mutual fund.
A portfolio manager actively manages the traditional equity fund. They buy and sell stock frequently in attempts to “outperform the market,” usually defined by a broad measure.. Index funds are passively managed. Their manager’s buy and hold only the stocks contained in their chosen benchmark. Their aim is to imitate returns, whether the market goes up or down.
They sell only when an investor redeems his investment or if a stock is kicked out of the Index. This passive investment saves money on research, salaries, and other overhead, and it avoids the emotional traps of buying at the top and selling at the bottom that torment active managers. The biggest saving for Index funds is the brokerage and other trading costs which active manager incur on their hyper active trading. In theory, this all leads to higher returns.
Which of the two is better? Let’s look at the odds. But with their growing numbers, it is difficult to guess how many will beat the benchmark in the long-term. And as the number of fund increase, it will get tough to pick the winners. And you will have to work to pick the right ones. But it takes little effort to pick an index fund that delivers almost the same return. You certainly won’t beat “the market,” but you’ll beat almost everyone working hard to make a choice.
Besides, index funds give you the diversity with discipline. You don’t run the risk of building large position in a small, illiquid company that concentrates you in one industry. Index funds give you a healthy dose of large companies that represent many industries, and the shares of these funds are easily bought and sold.
Which index fund should you pick? Every thing being equal the least expensive fund will be a winner. And recurring fund expense is a function of a funds size. The larger the fund, lower the expenses.
Besides, as an Index fund investor, you’re not getting any extra value. After all, the fund is merely trying to match the index. As you don’t need an advice to buy an Index fund, so you should never pay a sales charge on an index fund. But every Index fund (barring the tax saver) available today charges a load as they pay the fund sales man to sell the concept.