How Index Funds Work
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How Index Funds Work
Investment markets are very complex. To build a portfolio of securities that consistently outperforms all other portfolios can be difficult. Since index funds own the stocks that make up the index, the fund is designed to perform as well as the market measured by the index. Using an index fund gives these investors a chance to at least match the market. However, if their index underperforms another index, their index fund can do likewise.
Things To Know
- Index funds are designed to keep pace with their reference index.
- Different funds for the same index may weight their holdings differently.
Index funds have pros and cons
The advantage of index funds is that they are designed to keep pace with the market. Their downside is that they generally do not outperform the market. Some fund managers buy the top-performing stocks in the index instead of all the stocks in the index in an attempt to "beat the market." Such funds, however, are not considered true index funds.
Same index, different weights
Even index funds that use the same index can be structured differently. Some allocate their holdings evenly among the index stocks. Others allocate a greater proportion to bigger companies than smaller ones. That is why different funds that use the same index may have different returns.
Their competitive returns and lower management fees have made index funds popular for years. There are still management fees to consider, however, and they will vary across funds, so it would be wise to take the expenses into consideration. Lastly, like all investments, index funds have risk. If the benchmark the fund is tracking against is experiencing losses, it is likely that investors will have losses as well.
