A Guide To Low Cost Index Funds
If youâre thinking of dipping a cautious toe in the water of the stock market by investing in a managed fund, you may want to think again. According to the financial services company Motley Fool, a mere ten out of ten thousand managed funds have performed well over the last decade. So it may be a better idea to give consideration to low cost index funds instead.
What Is an Index Fund?
Essentially, index funds are a way of investing in the stock market without having to go through the process of picking investments for yourself. Traditionally, investing is all about buying shares in companies you think represent a good buy at the time, and selling them at a point where their value has â hopefully â peaked. It takes judgement, luck and a certain amount of technical know-how to make a success of trading in this way: so much so that even the professionals find it a challenge.
With index funds, also known as tracker funds, thereâs none of the usual necessity to pick winning stock and beat the market. Thereâs also no need to rely on the expertise of a fund manager to do that for you. Instead, index funds follow the performance of a particular stock market index.
What Is a Stock Market Index?
Stock market indices are key sources of information used by fund managers and other investors. An index provides a single-number summary of the performance of a particular selection of shares at any particular point in time. By comparing the values between one day and the next, itâs easy to see whether the market is strong or weak: if the index is up, people are buying shares (and making money), whereas if the index is down, the opposite is true.
There are a large number of stock market indices in existence, and youâre bound to have heard of at least some of them. The most famous include the FTSE 100, based in the London Stock Exchange: the Dow Jones, based in the New York Stock Exchange and NASDAQ: and the Hang Seng Index, based in Hong Kong. Itâs important to realise that stock market indices can be calculated using different methodologies, so theyâre not all directly comparable.
The Advantages of Index Funds
As touched on before, one of the biggest benefits of index funds is their simplicity. Thereâs none of the stress or research associated with picking stock market winners, so you wonât have to learn much â if anything â about financial markets. But the main benefit of tracker funds tends to be cost: youâre not employing the services of a fund manager, so you wonât be subsidising anybodyâs high-rolling lifestyle.
Having said that, not all index funds are cheap. Many come with substantial management fees and other associated costs, and if youâre new to investing itâs hard to know whether youâre paying over the odds. So before you commit, it pays to do some simple research to find out what products are available, just so you know what youâre paying for and what magnitude of fee is reasonable.
What Makes an Index Fund Poor Value?
Usually, if youâre investing in a fund which is actively managed for you, youâll be charged an initial fee consisting of 5% of your total investment, then a yearly management fee of around 1% of the fundâs overall value. Invest in an index fund and you shouldnât be charged anything up front, plus your annual management charge should be more like 0.75%. Where fees are concerned, less is more: because the percentages compound, you can end up paying a hefty chunk of your returns in charges.
High charges are to be avoided for another reason. They tend to radically worsen the impact of so-called âtracking errorâ, where the fund fails to accurately follow the chosen index. The effect of high fees can result in a wide divergence between the returns you should be getting and what you pocket in reality, a result which completely cancels out the main advantage of this kind of fund.
For anyone new to investing, or for those who arenât convinced fund managers are worth their keep, low cost index funds are an excellent option. As with managed funds, index funds donât come with a guarantee of good performance, but the costs associated with them are usually relatively low. However, some index funds come with higher fees, making it important to shop around for the right product.
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