What is an index fund?
Investing in an index fund is relatively straight-forward: you see that more and more people are investing in this investment product. But how can you actually invest in index funds? And what kind of indexes are there?
What is an index fund?
An index fund is an investment fund that strives to achieve the same return and risk as a certain stock market index. The fund does this by passively taking over the content of an index. Because the fund manager does not have to carry out any analyses himself, the transaction costs are usually lower than with a normal investment fund.
How can you invest in an index fund?
It is quite easy to invest in an index fund. You can choose to buy the index fund directly or to speculate on price differences with a derivative.
Participating in an index fund
The easiest way to participate in an index fund is to buy an ETF. An ETF is an exchange traded fund that you can buy and sell on the stock exchange just like a share. The price of an ETF then automatically moves with the price of the index.
A major advantage of buying ETFs is that transaction costs are low. At DEGIRO, for example, you can invest in a large selection of index funds without incurring transaction costs. Would you like to try this out? Use the bottom button to open an account:
Speculating on exchange rate fluctuations
You can also choose to speculate on exchange rate fluctuations in the short term. This can be interesting when there is a lot of volatility and you expect strong market movements. You can then, for example, speculate on a price rise or fall in the AEX. If you want to speculate on fast price changes, it is best to use a derivative.
A good party to trade CFDs in index funds is eToro. With eToro you can try out the possibilities completely free of charge with a demo. Use the button below to directly open an account with eToro:
What should you pay attention to when selecting an index fund?
There are hundreds of different index funds today. It is wise to compare the different options: in this way, you can determine which fund suits you best.
Types of investment products
Index funds can have all kinds of compositions. There are, of course, index funds that simply copy the composition of a stock market index. However, there are also more exotic funds that, for example, follow a composition of weed stocks or mirror the cryptocurrency market.
When investing in an index fund, it is therefore also important to consider what kind of risks you want to run. Do you only want to invest in safe securities such as bonds, or do you prefer to take some risks? First consider your risk appetite and determine how much risk you want to run: based on this you can decide which index fund suits you best.
Index funds can relate to different regions. Some indices contain shares of the whole world, while others only follow the price of specific countries. By investing in different regions, you can spread the investment risks as much as possible. It is often advisable to invest in several index funds: in this way you increase the chance of a positive return.
Not every fund has the same investment policy: some indices, for example, include dividends and others exclude dividends. When an index distributes a dividend, it can be reinvested or distributed. There is also a difference between fully replicated funds (where all shares in an index are tracked), partially replicated funds (where a selection is followed) and synthetic funds (where derivatives are used).
Index funds can also differ widely in terms of costs. Index funds are generally cheaper than traditional investment funds: this is because management costs are much lower. Nevertheless, it is important to stay sharp: some funds conceal all kinds of extra costs, and of course, you want to avoid that. That is why you should investigate carefully whether additional transaction costs are calculated and whether a surcharge is included in the price.
Another problem of some funds is that dividend tax is leaking away. For the MSCI World Index, for example, you lose around 0.5% each year in tax payments. Not all funds can reclaim these amounts for you: so pay close attention when you want to invest in an index fund.
Some funds also lend out part of your shares to other parties. This can be advantageous, as it gives the fund an extra return. However, lending shares also involves risks: the other party may go bankrupt, for example. Therefore, carefully examine what percentage the fund lends to other parties and with whom the risks lie.
What is an ETF?
An ETF is actually the same as an index fund with one clear difference: an ETF is tradable on the stock exchange just like shares are. This makes it easier to buy and sell participations, which is, of course, advantageous. An index fund is often only traded once a day, and you need to open a separate account with the provider to trade.
What is a tracker?
A tracker is actually a synonym for an ETF (and index fund). A tracker is an investment instrument that attempts to track the performance and risk of a stock market index.
What is an actively managed investment fund?
An actively managed investment fund is a fund that actively buys and sells shares on the basis of the latest market developments. A similar fund employs many analysts, all of whom have to be paid. As a result, the costs are higher than for an index fund: on average between one and two percent. To be attractive, the funds must therefore perform better than the market, which is often not the case. Therefore, be careful with investments in actively managed investment funds.
This is also reflected in how many of these funds operate. Many funds regularly change their name, which means that they remain positively known even when their performance is disappointing. It is also difficult to predict when the stock markets will perform well: in the period between 1996 and 2010, most of the profits were achieved on 10 specific days. If you did not own any shares during those days, your return would have been much lower.
What are good index funds?
When you invest in an index fund, you naturally want to achieve the best possible results. To achieve this, it is important that a fund has at least the following six characteristics. Does a fund not meet these requirements? Then it is better to search for another index fund.
In any case, it is important to choose a low-cost fund: even a cost difference of 0.1% can make a huge difference. This is because when you invest, you also receive a return on your return. As a result, over a period of 30 years you can quickly lose 20% of your return just because of that small difference in costs. Therefore, it certainly pays to invest in index funds with a cheap broker.
It is also smart to apply sufficient risk diversification. In this way you prevent your investments from performing badly because a certain sector or region is doing badly. By investing in a global fund, you benefit directly from developments in various regions. Of course, you can also choose to invest in funds from different countries.
It is also advisable to choose an index fund with a physical replication. This means that the fund actually buys the underlying shares and bonds. Imitations with derivatives, also known as synthetic replication, are often complex, and it is then difficult to identify the risks.
Minimal dividend leakage
A fund with minimal dividend leakage is also recommended. Many funds lose 0.1 to 0.2 percent in dividend because you cannot recover part of the taxes paid through your tax return. Investigate the amount of dividend leakage at the fund in question.
Large and efficient index fund
It is also advisable to invest in an index fund that is large enough: smaller funds often incur higher costs, which results in a loss of return. In addition, a large fund has a higher liquidity, as a result of which transaction spreads are lower. Therefore, look for ETF funds with an invested capital of one billion or more.
Finally, it is important that the index fund in which you invest closely tracks the index. Not all indexes are equally accurate: some funds have a so-called tracking error which may cause the results you achieve to differ from the results the index produces.
Why is it smart to invest in an index fund?
With an index fund, you can build up a nice, stable return over a long period of time. The costs of an index fund are often low, and you need to spend little or no time building up assets. Moreover, with an index fund, you benefit from risk diversification, which means your risk is lower than if you were to buy shares yourself.
What are the disadvantages of index funds?
With an index fund, there is little flexibility; the manager does not respond to market developments. With an index fund, it is also not possible to achieve a large profit in a short amount of time: after all, an index is the average for a broader market. Because you have no influence over individual purchases, you cannot control the investment decisions made by the fund managers.
Criticism of index funds
Index funds are not entirely without criticism. When more and more people switch to index funds, people are increasingly investing blindly. As a result, abuses at a company are less noticeable and can continue for a longer period of time. The subsequent crash of the stock could also be much greater when the abuse does come out
Index funds can also lead to greater fluctuations in the stock market. When people buy shares and a company is not performing well, they only sell the shares of that company. However, when the market is in a dip and people are selling their fund holdings en masse, there is a risk that the market as a whole will suddenly fall sharply as a result.
There is also a risk for index funds trading in illiquid stocks. When many people want to sell their holdings in the fund at the same time, it can be difficult to sell the underlying securities.
Despite criticism, index funds are still regularly recommended for novice and inexperienced investors. Warren Buffett, for example, also indicated that it makes more sense for most investors to buy an ETF on the S&P500 instead of selecting and buying individual shares.
What is the return on index investments?
The average return on the best performing indices is around 8%. You then have to take into account any additional costs. The moment at which you join also matters: it is therefore important to buy shares in an index fund on a regular basis.
How to buy an ETF?
Buying an ETF on an index fund is straightforward with most brokers. Within the broker’s platform, you can easily use the search box to find the fund you want to invest in. Once you have found the fund, all you have to do is enter how many units you want to buy. For example, if one ETF has a price of $80 and you want to invest with $800, you can buy 8 units of the fund.
You can also register with a company for an index fund. When you go for this option, you usually set up a fixed periodic deposit. This amount will then be automatically debited from your account on a monthly basis.
How does an index fund work?
An index fund mimics the actual index as much as possible. For example, the AEX is made up of an X amount of Unilever shares and an X amount of Shell shares. There are various techniques that funds use to simulate an index.
Many funds opt for complete imitation. In the case of full replication, each share in the index has the same weight in the index fund. In this way, the results of the index and the index fund are almost identical.
Some funds opt for partial imitation. In the case of partial imitation, a representative selection is made of shares within the fund. The price of the index fund may then differ slightly from the index.
Finally, there is sometimes an index fund that works through derivatives. In this case, the bank promises to pay out a certain return. However, this is more risky, as in the event of the bank’s bankruptcy, the investment becomes worthless.
Differences with an investment fund
- An index fund follows the index, an investment fund does not.
- The costs of an index fund are lower than those of an investment fund.
- The policy of an index fund is passive while an investment fund is actively managed.
Why invest in index funds?
Index funds are an excellent way to invest in a balanced way in certain markets or geographical areas. With the AEX, for example, you can invest in 25 shares of the most well-known and influential companies in the Netherlands. In this way, you automatically spread your risk: if you buy just one specific stock, bad figures from the company in question will immediately depress your entire result.
Index funds are a relatively safe way of investing. When you put money in an investment fund or share, the chances of a lower or higher return are greater. The price moves less because it concerns an average of many stocks.
Selecting an index fund
There are many index funds and here, too, it is important to make the right choice. The costs are an important factor to take into account. Higher fees can significantly reduce returns. Large funds are often more efficient and can therefore offer their services more cheaply.
Also check whether the fund tracks the index correctly. You can see whether the return of the index fund corresponds to the price development of the actual fund. Also check the location of the fund to research whether there is dividend leakage.
If you really want to invest safely, you can choose to invest as globally as possible. Global funds follow all stock markets together, sometimes combined with bonds or even real estate. In this way, you generally stabilize your investment results.
When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.