Are you the kind of person who wants to invest but does not have the confidence to hand-pick stocks and shares you think might do well? Or perhaps you do know a little something about the stock market, but you have neither the time nor the interest in putting forth the effort it takes to be successful with individual stocks. Well, there is an answer for you. That answer is index tracking funds.
A straight index fund is a type of mutual fund that tracks one of the major indices and attempts to reproduce its performance by investing in the most promising stocks within that index. A tracker fund is a more specific kind of index fund that tracks a certain segment of an index. For all practical purposes, however, there is no difference between the two. This is why they are often lumped together and simply known as 'index tracking funds'.
The key component that makes index funds so attractive is their status as passive investments. We will define passive investing in more detail in the next section, but for now, it is enough to know that passive investing is a lot easier for new investors and those who don't have a lot of time to put into developing and maintaining an investment strategy. As an added bonus, index funds tend to be less expensive for the investor.
Passive Investing Explained
The best way to understand passive investing is to think of a 'buy and hold' strategy. Rather than continually buying and selling, regularly turning over shares as an active investor does, a passive investor buys something and holds onto it for an extended period of time. Index tracking is the consummate form of passive investing.
Index funds do not continually try to spot and pick the hottest stocks and shares that could provide a boost for short-term growth. Instead, they follow a standard index like the S&P 500 or the FTSE 100. Fund operators track the performance of their chosen indices and make adjustments to their own investments only as needed to keep pace. This results in fewer transactions which subsequently reduces the costs for investors.
For individual investors, the benefits should be obvious:
- Greater portfolio stability
- Natural diversification to a certain degree
- Lower risk over time
- Potentially greater long-term yields
- Lower management and transaction fees.
How Index Tracking Funds Work
Before you start choosing index tracking funds to invest in, you should know how they work. Knowing how fund managers make decisions can help you better understand long-term performance.
Fund managers take a look at their chosen index or market sector to get an idea of historical performance. They then purchase stocks they anticipate will combine to generate a yield similar to the average of the stocks on the chosen index. They are not trying to beat the index as an active fund manager would – and there's a reason for that.
Common sense and historical data suggest that it is nearly impossible to beat an index consistently, over the long term. Stocks are too volatile, and it is very difficult to consistently choose the top performers with every transaction. When you add fees, charges and taxes into the equation, continually trying to beat an index tends to be a losing proposition.
On the other hand, tracking an index is easier because it attempts to replicate the overall performance of that index in a way that accounts for both highs and lows. This limits the ups and downs that often lead to substantial losses when active investors choose the wrong stocks. Think of it as making money by averaging.
How to Invest in Index Funds
The biggest incentive for investing in index funds is the lower cost. Simply put, there are a lot of inexpensive index funds out there. You can get involved with a minimal amount of money and relatively low risk, as long as you are willing to keep your money tied up for the foreseeable future.
Should you decide to do so, you can either work with a financial adviser, a fund manager, or a DIY index tracker platform. Each option has its advantages and disadvantages. Regardless of your choice, you at least need to do some initial research on your own to determine what index funds offer the most stability and the best historical performance.
Investing in a fund means you will be pooling your financial resources with other fund members to generate growth. It is to your advantage to pay attention to the regular reports fund managers send you so that you are kept abreast of performance. Should you decide it is necessary to pull out of one fund to invest in another, be aware that there will be charges involved.
A Slow and Steady Approach
At the end of the day, index tracking funds offer a slow and steady approach to investing. Rather than focusing on potentially volatile active investing that could generate significant short-term yields, index funds favour passive investing that relies on the natural course of chosen indices.
An index fund is a good place to start if you are new to investing. You might want to sit down with a certified financial adviser to learn more about how all of this works. Do not be afraid to get multiple opinions, either. You'll never go wrong seeking out advice before you invest in anything.