“An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500).” – Investopedia.
Warren Buffett considers index funds as a haven for savings for retirement plans. Investing in Index funds is aimed to match the performance of the capital market rather than beat it. Index fund investing is usually passive investing for the long term. Index Funds provide diversification by investing across many stocks.
Since most investors or traders lose more money than they make by picking the individual stocks and trying to time the market. An index fund provides an excellent option for risk management, compounding the money and match the performance of the stock market or even beat it. Unfortunately, there are no index funds in Nepal.
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Index Fund Vs. Mutual Fund
Index funds invest in overall stock market while mutual funds invest in any listed securities or stocks as the investment manager sees fit.
Investment goals: An Index fund tries to replicate the returns of the overall stock market index. While the mutual funds invest to outperform the market.
Management method: Index fund is passively managed while mutual funds change securities or stocks holdings frequently for short-term gains.
Management fee: Index funds being passively managed have management costs very low or next to zero. Index funds average expense ratio in US ranges from 0.02% – 0.2% and that of mutual funds falls around 0.5% – 0.75%.
Some of the best performing mutual funds in Nepal with high dividend capacity in 2021 are Global IME Samunnat Scheme 1 (GIMES1), NIBL Pragati Fund (NIBLPF), Sunrise First Mutual Fund (SFMF), Sanima Equity Fund (SAEF), etc.
Some popular examples of index funds (global) are: The Vanguard 500 Index Fund (VFIAX), The Fidelity 500 Index Fund (FXAIX), The Schwab Total Stock Market Index Fund (SWTSX), The Fidelity International Index Fund (FSPSX) etc.
Like in every other investment strategy, investing in index funds also has some advantages and disadvantages. Let’s look at the pros and cons of index fund investing.
Advantages of Investing in Index Funds
1. Satisfactory Return In Long Run:
Investing in index funds always pays off in the long run. This investment option is very effective for an average investor. An investor with $10,000 at the start of 1969 who invested in a Standard & Poor’s 500-Stock Index Fund would have had a portfolio worth $1,092,489 by April 2018, assuming that all dividends were reinvested. A second investor who instead purchased shares in the average actively managed fund would have seen his investment grow to $817,741. This is quite a massive difference. The first investor was 25 percent ahead of the actively managed fund.
An investors’ money is diversified by the index fund in different sectors of the listed companies in the stock market, this considerably minimizes the risk. Moreover, most of the index funds invest only in fundamentally sound, large caps and dividend-paying companies. So, there is low risk and pretty good returns in the investment.
3. Low Fees:
Most of the traders lose a lot of money in broker commissions and fees. Well, this can be effectively minimized and controlled by investing in index funds. Index funds cost very little fees. While Mutual funds or non-index funds ask for more fees than index funds. Saving money in transactions and broker payment can save one some handy money.
Disadvantages Of Investing In Index funds
1. Lack of Flexibility
When it comes to investing by index fund managers, they have some restrictions and are bound to follow the policies and strategies. For instance, the Standard and Poor’s 500 (S&P 500) index can only invest in the 500 large companies listed in stock exchanges in the United States. So even though there is an opportunity for financial gains in some other small-cap companies the index cannot invest in them.
2. Limited Gains
The chances of huge financial gains are very minimal. With less risk, there are few chances of impressive rewards. Index funds can only help keep up with the market but not beating it.
3. Less Likely Winner In The Short-term
For those who want to make impressive profits in the short-term or during the swings of the market, an index fund couldn’t be their ideal choice.
Some widely recognized popular indexes are:
- Russell 2000 index
- Wilshire 5000 Total Market Index
- Standard and Poor’s 500 indexes (S&P 500)
- Bloomberg Barclays US Aggregate Bond Index
- Nasdaq Composite index
- Dow Jones Industrial Average (DJIA)
- Nifty fifty index
- Nikkei 225 index (or the Nikkei stock average)
Why Index Fund Is Necessary For Nepal?
The capital market of Nepal has been growing at a good pace in recent times. The IPO’s (Initial Public Offerings) being issued every next month, there are many listed companies to choose from. There are small-cap and large-cap companies, some are growth companies while others are slow growers, some companies pay handsome dividends while others don’t have the potential to pay dividends. Many new investors are entering the market every next day. These amateur investors can’t make a winning move now and then increase the risk of losing money.
It’s more often the smarter person in the society who loses the money in the capital market, say a doctor or an engineer. A doctor knows his trade well, but that doesn’t guarantee his success in the stock market.
Index funds come in handy for those who want their hard-earned money to be guarded in the risk-bearing capital market. Everyone doesn’t have to analyze the fundamentals of the company or the trend of the market. An index fund can be a good option for those who want to be part of the capital market and make decent returns but don’t have time to analyze the market. An index fund is an ultimate way to save extra expenses, fees, and commissions given to brokers, and employing minimal time to match the market returns.
An index fund provides an average investor with an opportunity to invest in the best companies (financially strong) without having a glance at the listed companies’ performances. The importance of index funds cannot be more emphasized in a country like Nepal where the economy is rapidly growing.
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