Index funds allow the average individual who may not know the ins and outs of the stock market to invest intelligently by offering stock diversification and by reliably delivering average market performance. In essence, they are a type of fund, mutual or exchanged traded, designed to track and mirror the individual stocks contained in a market index, like the S&P 500. Ever since the first index fund was launched in 1975, investors have been debating the merits of active versus passive portfolio management. The discussion is multi-faceted and is both practical and philosophical.
Who uses index funds?
Index funds are ideal for those who wish to invest in the stock market and have their portfolio closely duplicate what the market is doing without having to be educated in the art of investing or putting too much of their time into monitoring their portfolio.
Advantages
Equity Index funds are run in a way that minimizes portfolio turnover (they trade less often and minimize costs and taxes), also known as high passivity. They also provide broad market exposure, so portfolios are spread among many stocks and not concentrated within a few. They also are more useful in very efficient segments of the market such as the S&P 500.
Disadvantages of index funds
The primary disadvantage of index funds is their risk level. Are most investors able to define and measure the amount of true investment risk they are taking? Not usually. Can investors identify the benchmark index that best matches their objectives and constraints? Usually less often then you think. Do index fund studies properly incorporate a cost-benefit analysis of the advice, counseling, education, hand-holding and safeguards against behavioral errors that investors receive from their advisors? Nope. Additionally, Index Funds also follow stock indexes to the downside when a good active manager may have been able to limit the impact of the downside volatility of a portfolio by hedging, moving to cash or rotating into less risky segments of the market.
In the end, it’s always best to consult with your financial advisor before deciding where to invest your money.