Advantages and Myths of Index Funds for Investment

This text discusses the advantages and myths of index funds for investment. It explains how index funds are tax efficient, diversified, and passive. It also highlights the reasons why index funds can underperform and how to maximize their performance.

Securities Analysis and Portfolio Management
There are various advantages which come along with proper investment in index funds. Due to
their low turnover, index funds are tax efficient and this aspect decreases the transaction
expenses rendering them less expensive to manage (Mullins, 2014). They guarantee to give the
investor nearly exactly the market’s return less the low fees he/she pays. What is more, index
funds have a broad diversification and thus the investor does not have to be anxious about
concentration risk of having all his eggs in a single basket.
It is true that index funds are safer as opposed to individual stocks since they have the highest
possible diversification. This makes them the most suitable for all investors including new ones
who are aiming at having a more diversified and safe portfolio. Balanced index funds provide the
investor with an ideal way to have a diverse mix of bonds and stocks in just a single mutual fund.
Due to these features, the myth that index funds are safer bets is true and people who venture in
them place their money in the right places (Schad, 2018).
It is not always true that index funds match exactly the funds they track because sometimes they
end up having a different return than their index. This occurs due to an array of characteristics of
a given fund which include transparency of fee reporting, how reasonable the expense ratio is, its
degree of turnover as well as its frequency of rebalancing. Owing to the fluctuations of these
characteristics, index funds do not always match the funds they track. Many investors are
bewildered when their index return fails to match that of the index its tracking and this happens
when they only consider one factor that is index and ignore the rest (Cremers, Ferreira, Matos, &
Starks, 2016).

It is true that index funds are a form of passive investing because the rate of return for every
index is affected by the performance of all companies that are in it, which can balance each other
out. Take for instance an investor who buys an index which contains only 2 companies and one
of them goes up say by 3% while the other goes down by 2%. In such a case then he/she will be
still up by 1% overall. In a nutshell, indexing is passive category of fund management which has
been doing well in surpassing most actively mutual funds (Fichtner, Heemskerk, & Garcia-
Bernardo, 2017).
However it is wrong to argue that index funds perform consistently because due to various
reasons they can underperform their benchmark. Kulp argues that one of the reasons is high
expense ratio that might include concealed costs rendering an index fund expensive (Kulp,
2018). Another one is turnover which refers to the way assets in the fund vary. In a mutual fund
index, a high turnover leads to an expensive fund and vise versa. So, as investors put their
monies in index funds, they should be aware that they can underperform and thus make active
decisions tailored to maximize their performance.
It is incorrect to argue that index funds are good for short term since for the majority of long-
term investors, anytime can be the most opportune time to put money in index funds.
Nevertheless, there are particular market conditions which provide index funds with an
advantage over their actively-managed counterparts. Actually index funds are in general the best
speculation options for long-term ventures. This is mainly because their low-cost structure and
passive nature provide a performance edge which aids them to beat most of the actively-managed
funds in the long-term. Lower expenses in general translate into better long-term proceeds
(Bebchuk, Brav, & Jiang, 2015).

References
Bebchuk, L. A., Brav, A., & Jiang, W. (2015). The long-term effects of hedge fund activism (No.
w21227). National Bureau of Economic Research.
Cremers, M., Ferreira, M. A., Matos, P., & Starks, L. (2016). Indexing and active fund
management: International evidence. Journal of Financial Economics, 120(3), 539-560.
Fichtner, J., Heemskerk, E. M., & Garcia-Bernardo, J. (2017). Hidden power of the Big Three?
Passive index funds, re-concentration of corporate ownership, and new financial
risk. Business and Politics, 19(2), 298-326.
Kulp, K., (2018). 5 Myths Everyone Should Know About Index Funds. U.S. News & World
Report L.P. Accessed on 18/12/2018. Retrieved from:
https://money.usnews.com/investing/funds/articles/2018-04-03/5-myths-everyone-
should-know-about-index-funds
Mullins, W. (2014). The governance impact of index funds: Evidence from regression
discontinuity. Work. Pap., Sloan Sch. Manag., Mass. Inst. Technol.
Schad, R. (2018). Competition Between Volatility and Overall Market Gain and the Performance
of Leveraged Index Funds. International Journal of Financial Research, 9(3), 20.