Saturday, June 28, 2014

Index Funds

Roughly speaking an index measures the performance of a segment certain market, for example the stock market.  In the Philippines when people talk about the stock market going up or down, they usually mean the PSEI (Philippine Stock Exchange Index).  The composition of the index is not permanent.  From time to time stocks are added and removed from the index.

An index fund attempts to track the performance of an index.  When the index goes up or down, the fund NAVPS/NAVPU should also go up or down by the same percentage.

Who should invest in index funds?  Investors who:
  • believe that over long time periods the index tends to go up.  This is backed-up by historical data, but of course "past performance is not a guarantee of future returns".

  • want to invest in the index but don't have enough cash to invest directly in stocks that make up the index.  Replicating the index by buying shares in individual companies is quite expensive.  Investing in a fund allows the investor to invest in the index for a relatively low amount.

  • want to invest in the index but don't have the time or inclination to manage a portfolio of stocks.  When the index composition changes, the investor should buy and sell shares to mirror the index's new composition.  Investing in a fund allows the investor to "set-and-forget", in other words to invest and let the fund do the rest.

  • want to invest in an equity fund with lower fees.  Theoretically, an index fund should be passively-managed and have a lower annual fee than actively managed funds.
Who should not invest in index funds?  Investors who:
  • believe they can outperform the market.  Doing this is very difficult over a long time period.

  • want control over which stocks to buy or sell.

  • want control  over when to buy or sell.
What should investors look for in an index mutual fund?
  • Accurate index tracking - if an fund doesn't accurately track the index's movements, it's not an index fund.  The deviation from the index is called the tracking error, the lower the better.

  • Low fees - there's no reason for an index fund to charge a high fee
In the next posts we'll take a look at the equity index funds available in the Philippines:

Index Funds Part 1
Index Funds Part 2

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