What Is an Index Fund?
By Janet Hoffman
November 2, 2021
If you are interested in diversifying your portfolio and would like to remain cost and tax conscious, index funds may be a great solution! The question you may be asking is, “What are index funds?”
Index Funds are portfolios of stocks, bonds and other asset classes. They are designed to parallel the makeup as well as the performance of a financial market index, such as the Standard & Poor’s 500 (US stocks) or the Barclays Aggregate bond index (US bonds). Another term for an index fund is passive fund where the goal is not to beat the index but to match it.
The role of a “benchmark” or “index” is a comparison for a portfolio and plays an important role in investment management. For example, a portfolio may be allocated 60% to equities and 40% to fixed income. An investment manager might assume 60% S&P 500 (US equity) / 40% Barclays Aggregate (US bond) as a weighted average benchmark for comparison purposes. It is equally important to select benchmarks that are the most representative of your portfolio composition and we at Sand Hill take many benchmarks or indices into consideration, not just US large company stocks and US bonds.
We view index funds as a very important part of an investing strategy, but we also believe that there is a time and place to incorporate some “active” managers. The objective of an active fund is to deliver performance in excess of a traditional benchmark. We use active managers to give our clients exposure to areas of the financial market that tend to be less efficient. This inefficiency is often driven by a lack of Wall Street coverage and/or a less understood part of the market. Active managers typically have a team of investment professionals who are selecting investments they believe to be undervalued.
There are several advantages to investing in a passively managed index fund to diversify your portfolio. The holdings are generally transparent as the holdings of at least the best-known benchmarks are widely reported. An index fund’s expense ratio—a component of every mutual and exchange-traded fund—is generally much lower than a more actively managed counterpart. Index funds are also generally more tax efficient than their active counterparts due to less trading within the fund (known as turnover).
To answer the widely posed question, “How easy is indexing?” in short, it is NOT easy. As with any fund, a well-run index fund has many moving parts. A good fund needs to be very liquid and charge a low fee. Some passive fund managers engage in activities such as securities lending that allows them to generate excess returns that more closely match those of the benchmark they track. The fund manager needs to allow for fund inflows and outflows without disrupting returns for existing shareholders. The fund needs to address corporate actions for the underlying companies and effective management of adding and dropping companies from the benchmark. For example, Standard & Poor’s will publish adds/drops from the benchmark every few months; an index fund must make those changes in a timely manner and work within the possibility of price changes of these stocks related to whether they are being added (increase in price) or dropped (decrease in price).
At Sand Hill, we incorporate both passively and actively managed strategies within your portfolio. If you are interested learning more about index funds, speak with a Sand Hill Wealth Manager today.
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