Index funds - what is it?

An Index fund is a collective investment scheme. It replicates the movements in an index that it is following. The underlying stocks are held constant regardless of market conditions. This is achieved by trying to hold all the underlying stocks in the index in the same proportion as the index itself. There are several indices that are tracked by the index funds. The more popular are the Dow Jones Index, Nasdaq, Russel 2000, Wilshire 5000 and TSX 100.

The market is assumed to be smart and would deliver good returns in the long run.  Many funds use computers with very little human intervention, as the computers need to follow the movement in the market. This is a passive form of management.

There are several advantages to the holders of index funds. Low cost is the most important. By virtue of a passive form of management, the costs can be as low as 0.15%, whereas in an actively managed fund, the lowest would be around 1.75%. Other things being equal, if both types of funds have the same pre-expense returns, the index holders would have a higher return by 1.60%. Compounded annually over a long term can make a substantial difference to your capital.

Clarity of objectives. When you know the underlying index that is tracked, you have clarity of objectives. There is also no drift where money managers chase higher returns and drift away from the fund objectives. Turnovers. Passive management results in lower turnover than active funds. Turnovers lead to frictions which lead to costs such as brokerage,commission,capital gains taxes etc. All this translates to lower earnings for the holders in actively managed funds.

They are not without disadvantages. The main disadvantage is that a passive fund cannot outperform the index. An active fund may outperform the index in some years. Tracking errors that are the gap between the holdings and price in the index compared with the actual holdings may sometimes lead to tracking errors.

Overall, over a long term, following an index and having a low cost year over year are great benefits in owning an Index fund.