The Easiest Way to Build Wealth
"The 21st century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners — neither he nor his 'helpers' can do that — but should rather be to own a cross-section of businesses that in the aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal."
This quote from Warren Buffet might raise two questions: why does the world's most famous stock picker love passive investing? And what are these index funds that are being referred to here?
Well, we're here to answer the latter: what are index funds? Hopefully, all the rest should follow.
In simple terms, an index fund is a type of exchange-traded fund (ETF) or a mutual fund whose portfolio is constructed to track or match components of a financial market's index. In this case, Buffet is referring to America's S&P 500 Index.
Index funds help in portfolio diversification, which is why they are attracting new investors every day. Please don't take our word for it.
Look at the numbers -inflows into index funds in India have tripled in the past 2 years, now making up nearly half of all equity fund inflow. These are funds that invest in a broader market index, like the Sensex of Nifty. And an increasing number of people want to be a part of them. Let's find out why.
Index Funds vs Actively Managed Mutual Funds
Index funds and actively managed mutual funds can be distinguished from each other on four broad factors:
- The objective of investing in the fund,
- The decision-making process in their investments, and
- The fees that investors pay to own it.
- Choice (thousands of mutual funds to choose from, past performance not really a good metric). Index funds make choices simpler while giving you the same effectiveness. This is why index funds are the easiest - because they solve choice paralysis.
Managing an active mutual fund requires making decisions regularly by a professional fund manager. The manager's objective is to outperform the market using strategic choices. However, there is no need for that same level of constant human oversight in managing index funds - they simply mirror their underlying index's performance.
The most significant difference to any investor is the overall cost. The more resources and expertise you rely on to manage funds, the more will be the cost you'll incur. These costs include investment manager salaries, bonuses, employee benefits, office space, and extensive marketing to attract investors. This fee is paid by the mutual fund holder and is called the total expense ratio.
But index funds cost a lot less money in comparison, which makes them a desirable alternative.
Why you should opt for Index Funds
Index funds have made their mark on investors and the broader market, and rightly so, making them fairly popular in recent times. Let's take a closer look at a few:
- For investors who prefer more predictability in returns, index funds are ideal. Since these funds track a market index, the returns are very similar to those offered by the index.
- Risk of poor performance is lowered in index funds investments. In an actively managed fund, the fund manager chooses stocks, themes, and sectors based on his experience and conviction of the future. There may be instances where he may go wrong and the fund will suffer in returns. Since index funds are passively managed, such risks do not arise.
- For investors who prefer low-cost investment alternatives index funds are once again ideal. Fees saved over long periods could make a significant difference in overall performance.
Once you decide to opt for an index fund, it is crucial to make the most plausible selection. While selecting a fund, analyze it from several different perspectives - your investment horizon, risk appetite and more. Check out this guide to passive investing of beginners in Indiafor help, or this introduction to index funds.