What's with Index Funds?

We’ve all heard from Mr Warren Buffet, either directly or indirectly (through social media) about this. If you haven’t, here is an excerpt from the Berkshire Hathaway 2013 shareholder letter: “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

I’ll get to Government Bonds in another article. Let’s talk about Index Funds today.

An “index fund” is a type of mutual fund that seeks to track the returns of an index. The S&P 500 Index (USA) and the Nifty 50 Index (India) are examples of market indexes that index funds may seek to track.

So why does Mr Buffet ask you and me to invest our money in these funds instead of specific companies like he does? Well, there are a number of roadblocks in front of us as retail investors. I talked about them here.

Now, coming to the benefits of index funds. One, they help you with diversification. You don’t have to go looking for individual companies in every industry you’re interested in, you have a part of all the companies in the respective index. Two, the fees associated is generally low, mainly because the fund managers have to copy the index composition only and not use their expertise too much. Three, the risk is lower than most other types of funds or stocks since indices typically would contain companies which have performed financially and management-wise adequately for at least a number of years. Four, not much research is needed since an index already would have the best companies possible for the respective industry/country.

On the other hand, with index funds, your return potential is capped, that is, you would almost never beat the market (because of tracking error- deviation from the index and fees). You would also have no control over the composition of the fund, that lies with the fund manager.

In short, if you want returns at par with the market, with low risk and little research than most other instruments, you can choose to invest in index funds.

There is another instrument to mirror the markets along with index fund: ETFs but I’ll be back with another article for that. This is it for this article.

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