What Are Index Funds and What Are Their Advantages?

Can you imagine investing in a complete index? This is the rationale of indexed funds. Its advantages come from its philosophy: they do not try to beat the market, but to follow it.

The index funds have a policy as simple as effective, and like any investment fund, make up a portfolio of assets, but these funds do not try to beat a benchmark: replicate the index and flow with it. The saver has the possibility of investing in the set of values ​​that make up the index (for example, the IBEX 35 or the Standard & Poor’s 500) without having to worry about buying the securities individually in the same proportion.

HOW ARE INDEXED FUNDS MADE UP?

The bulk of equity investment funds are made up of indexed funds (also called index funds). They are passive management investment funds, in which the manager does not try to beat a benchmark index through a strategy of selection and allocation of values ​​(Asset Allocation).

An index is a set of assets that are taken as a reference to determine the direction of a market. Take as an example the IBEX 35, index of the Spanish continuous market.

If we want to know how the Spanish stock market has behaved in the last year, in general, we should take all the values ​​that comprise it, see its evolution during this period and make an average of the ups and downs. However, it would not be a simple average that would give us the answer, since there are values ​​that have a greater weight within the market (there are more significant actions than others).

The stock indexes, such as the IBEX 35, were created so as not to have to carry out this arduous task: they take those actions of greater weight, the ones that have more importance within the market and a weighted average of their movements are made. In this way, it is possible to know if the Spanish stock market has risen or fallen. The indices have a high representation of the market as a whole.

Thus, when investing in an index, in reality, what is being invested is in a market as a whole. If the market has a good performance, it will be reflected in its index and, ultimately, in the profitability of the indexed fund.

The philosophy of this type of funds is simply that the market itself is efficient, that is, it makes no sense to fight against it: the most sensible thing is to follow it.

It is possible that, during a recessionary period, the refuge is found in the selection of values ​​(opting for those more defensive). It is even possible to obtain a higher return than the market in any given year. But, defenders of passive management (such as that carried out by indexed funds), warn that the market is unbeatable.

CAN A PARTICULAR INVESTOR MAKE A SIMILAR INVESTMENT STRATEGY?

In principle yes, nothing prevents it. Simply by taking a stock market, anyone who believes they can experience growth, observing the index that represents it, taking their values ​​one by one and investing in the same proportion can compose an “indexed” portfolio of securities.

However, it should be remembered that not all securities have the same weight within the index, in the case of IBEX 35, stock market capitalization and trading volume are taken as a criterion to give importance. This is where the first problem may appear when trying to replicate an index, the particular investor must calculate the exact percentages (or as close as possible) to the composition of that index.

You should also adjust them periodically because there are changes in the index over time. It is what is known as the rebalancing of the portfolio.

Also, trying to replicate an index will require a certain level of capital. In case of forming a portfolio indexed to the IBEX 35, the saver must invest in the 35 securities that compose it according to their proportion.

We have used the IBEX 35 as an example, consisting of 35 actions. However, can you imagine what it would mean to compose a portfolio that replicates the 500 values ​​of the Standard & Poor`s 500? Indexed funds, as they are collective investment products, offer a complete portfolio with simple participation, without all these complications.

NOTE: There are also fixed income indices, such as the Global Aggregate Float Adjusted Bond Index. An example is the HSBC Global Emerging Market Government Bond Index Fund, an index fund of the public debt of emerging markets (reproduces the JPMorgan EMBI Global Diversified Total Return Index). Thanks to indexed funds, it is easier to access this type of passive management investment.

WHAT ARE THE ADVANTAGES OF INDEXED FUNDS?

Historically, the stock market has always experienced long-term growth (of the order of 8-10% per year, on average).

Stock markets have their ups and downs in the short and medium-term, but some studies show that it is the best investment in the long term: society advances, technology evolves and the economy grows. A clear example is the evolution of Standard & Poor’s 500 since 1975.

If the stock market itself offers long-term profitability, why try to beat it through active stock management?

In any case, even without wanting to act as defenders or detractors of passive management, index funds provide a series of undeniable advantages.

Commissions are reduced

Active management requires more work, more asset sales, market research, calculations, portfolio adjustments, etc. A manager has a more complex task and, therefore, demands a more complete team and more bulky fees.

With indexed funds all this is not necessary, these financial products require passive management. Simply by building a portfolio that replicates the index and periodically readjusting it, the fund is maintained and the fees are reduced.

It is possible to change markets without paying for it

Do we think it is time to leave the European markets and start allocating capital to Wall Street? Thanks to the indexed funds we will be able to transfer our shares from one fund to another with a tax exemption.

The fact of being able to rotate our savings from one market (represented by an index) to another without assuming any fiscal cost means being able to always be in the one with the best present evolution. With the shares, a 19% withholding will be applied each time a sale occurs. In the end, our savings decrease.

Dividend Management

Most stock indices do not take into account the dividends distributed to calculate them (except the so-called “Total Return” indices). This means that, if you invest in an index fund that purchases the shares in cash, you will get a higher return thanks to the dividends of the shares.

Also, a tax reduction is applied to accumulation funds (which add dividends to the fund’s assets): they are taxed at 1% each time a dividend is distributed.

Automatic diversification

By buying shares of an indexed fund, all the values ​​that make up the index that is being replicated are being accessed.

Indexed funds can offer us a wide diversification. Imagine that we invest in a fund that replicates a world index: geographic diversification would be total.

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