Index investing is the one-stop all inclusive choice for the passive investor. What is a passive investor? It is an investment strategy which focuses on the long run to maximize returns and keeping trading to a minimum. The thought process is by avoiding fees, the investment base does not get eaten up.
Passive investors love index investing because it takes all of the guesswork out of investing decisions. Index investing involves buying a fund that seeks to replicate the returns of a particular index. The two most popular ways of investing in an index are through index mutual funds and index exchange traded funds.
Let’s take a look at the advantages and disadvantages of index investing.
Advantages of Index Funds for the Passive Investor
- Ease Of Use: The biggest advantage of index investing is that it does not require any work on behalf of the fund investor. All that you have to do is pick the index that you would like to follow and the index fund does the rest. Your returns will be right in line with the performance of a particular index over the course of that year. The most popular index funds follow the S&P 500, the Dow Jones, and the NASDAQ.
- Low Fees: Since index funds are not actively managed, their fees are lower than regular mutual funds. Actively managed funds have a much higher turnover rate which increases the fees that investors have to pay. These trades generate short term capital gains for fund investors. The only turnover in an index fund is when a stock is added or removed from a particular index.
- Better Performance: Index funds have historically outperformed actively managed funds. They have boasted higher returns due to their lower expense ratios and lower fees. Index funds offer higher returns by diversifying a portfolio at a low cost to the fund investor. Their after tax returns have made them attractive investment vehicles for investors.
Disadvantages of Index Funds for the Passive Investor
- Inability to beat the market: Since index funds track the moments of the market as a whole, they lack the ability to outperform the market. Actively managed portfolios can adjust their portfolios to take advantage of areas of the market that are outperforming. During times of great economic growth, your returns may actually underperform actively managed funds.
- Fund Performance: Index funds can do particularly poorly during bad economic times. For example, if you invested in a S&P 500 index fund in 2000, you would have actually lost money over the past decade. If the U.S. economy goes through another economic period of little to no growth, index funds will continue to underperform.
As you can see, index funds have their advantages and disadvantages just like retail mutual funds. They are however a good investment vehicle for the passive investor looking for quick and easy diversification at a low cost.