Understanding Index Funds
By Saghir A. Aslam
Rawalpindi, Pakistan
(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the Ummah will benefit from this effort through greater financial empowerment, enabling the community to live in security and dignity and fulfill their religious and moral obligations towards charitable activities)
[Funds that track the Market may have lower costs, but are they always the best option?]
Every business day, the media report what happened in the financial markets. Was the Standard and the Poor’s (S&P) 500 or the Dow Jones Industrial Average up or down for the day? Did the Russell 2000 - which measures small-cap US stocks - strengthen or weaken? While those numbers tell you something about the financial markets, they don’t necessarily tell you how your portfolio performed. After all, the S&P 500 has 500 companies in it, and though considered a good represent of US equities, it doesn’t necessarily represent your individual portfolio.
For most individual investors, accumulating shares of all the companies in the right proportions to match the S&P 500 is prohibitively expensive. Or at least it was, until the mid-1970s when a new investment vehicle first appeared. “Index funds came along and they to fill that void, almost tried to democratize investing,”. “The way most people should think about index funds is as board, passive, cheap vehicles.”
Index funds are the form of passive management, where the funds replicate the performance of a specific index of investments. One of the primary strategic advantages of index funds is that they typically have low operating expenses. It’s the opposite of active management, where a portfolio manager tries to pick selected equities or investment vehicles that will outperform during a specific period of time.
Index funds got their start in the mid-1970s, as mutual fund companies realized for the most investors, buying shares of everything’s in the S&P 500, was cost-prohibitive. As more people invested in these index funds, managers developed funds for additional indices.
“What an index fund allows you to do is maintain a dynamic allocation that evolves over time as the economy evolves.”
In the beginning, index funds were weighted by the market capitalization of the stocks comprising the index. When it resulted some of those indices being overinvested in pricier stocks, Samana says people started coming up with the alternative weighting factors, such as revenue and valuation, in the hope of preventing investors from being concentrated in the most expensive stocks.
- Passive or active management?
Proponents of index funds and passive management principles generally argue that over time these kinds of funds which reflect the market sentiment, will outperform an actively managed fund. Others have the opposite sentiment. “Some people would have you believe that active management is the only way to go.”
“They spend lot of time looking for the right active managers.” But active management is controversial, it is typically more expensive than an index fund because it requires more work on the part of active managers. Expensive ratios are typically higher for active-management funds, meaning that in order to beat in index it needs to outperform it by more than the difference in operating expenses.
Many investing theories believe active managers can’t consistently match or beat board market return rates, especially after factoring in fees.
But there may be many cases where active management works out better, “When you step away from large caps, which would include the bulk of the companies in the widely known S&P 500, and venture into areas such as small-cap stocks or merging markets where individual security information isn’t as readily available and may require more research, you start to see where value is really added by active management in some of these areas of the market”.
That in terms of investors opinions, passive index funds - even in efficient assets sectors such as US large-cap stocks - isn’t a solution to all of your investing needs. Instead, work with your advisor to craft your portfolio and determine your asset allocation based on your investment goals and risk tolerance. Just like you wouldn’t want to only win one equity, you may not want to solely rely on one strategy – passive or active.
(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, nor does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr Aslam does not have anything for sale.)
