MSG Team's other articles

10032 Investment Banking and Special Purpose Acquisition Companies (SPACs)

Special Purpose Acquisition Companies (SPAC) have become all the rage in the investment banking industry. They are not a new concept. They have been around for quite some time. However, they have become quite popular in the recent past. For instance, in the first half of 2020, $13.5 billion dollars were raised by Special Purpose […]

9257 External Credit Enhancement in Infrastructure Financing

Infrastructure projects continue for a long period of time. Sometimes these projects continue for decades. Hence, they need long term finance. On the other hand, there are entities such as insurance companies and pension funds which are looking to invest their money for long periods of time. Ideally, insurance companies and pension funds should be […]

10993 Return on Assets (ROA) – Meaning, Formula, Assumptions and Interpretation

Another metric that is widely used by investors to gauge the profitability of a company is Return on Assets (ROA). More about this very important ratio has been stated in this article. Formula Return on Assets = Earnings / Asset Base Some calculations may include intangible assets while some others may exclude them from calculation […]

9289 Factors to Consider While Using the Retail Inventory Method

The retail inventory method is used by retail corporations across the globe to obtain a rough estimate of the ending value of inventory held by them. However, the cost price is calculated as a percentage of the sales price. Since the sales price fluctuates significantly over time, calculating the estimated cost price can become a […]

12995 Cryptocurrency Wallets – Meaning and Different Types of Wallets

The ownership and storage of cryptocurrencies are quite different as compared to regular currencies. It is for this reason that people who are new to the crypto universe find it challenging to understand how the storage and transfer of cryptocurrency works. Cryptocurrency wallets are one of the most popular ways which are used to store […]

Search with tags

  • No tags available.

People who invest their money in stocks can be split up into two categories. One category of people actively decide which stock they want to invest their money in. This means that these investors spend their time and money doing research on individual stocks. On the other hand, the other category of people invests their money but do not have the time or the inclination to pick individual stocks. These investors are called passive investors.

Common sense dictates that people who manage their money more actively should ideally get a better rate of return on their money. However, this is not what happens in reality. When empirical data is considered, the results are counterintuitive. It turns out that people who have been investing their money passively end up making a much better return on their investments. The ones managing their money actively are simply making too many mistakes while choosing their stocks. This is the reason why some of their bets pay off handsomely while others do not. In the end, they average less than people who invest their money passively.

This is the reason why Index funds like Vanguard and S&P are extremely popular with investors. When these funds were first launched, people thought that they were a surefire way to achieve mediocrity. However, over a period of time, these funds have become more acceptable.

In this article, we will have a closer look at the benefits that index funds offer over other investment options.

Diversification

Picking individual stocks is risky as well as time-consuming. Many investors have full-time jobs. Hence, they do not have the time or the inclination to pick out the best stocks. Hence, if they invest in individual stocks, they are likely to make a mistake. On the other hand, when an investor invests in index funds, they immediately obtain a small slice of several different stocks. None of these stocks comprise more than 4% or 5% of the entire investment. Hence, the performance of individual stocks cannot really alter the performance of these funds. This approach of allocating the money amongst all the blue-chip stocks in the market has proved to be less risky and more rewarding since it facilitates diversification.

Low Expenses

Index funds are more effective as compared to mutual funds. This is because of the extremely low expenses that these funds incur. Firstly, it needs to be understood that actively managed mutual funds have an entry as well as an exit load. This is done to make up for the marketing and advertising charges that are incurred by mutual funds. Since these charges are not incurred by index funds, they work out to be the cheaper alternative.

Also, mutual funds have to hire a research department whereas index funds do not have to do so. Since the job of index funds is only to mirror the markets, not much research is required. Also, index funds do not need to hire star index performers since the job of an index fund manager is only to mirror the market. Hence fancy management degrees and market-beating strategies are not required at all!

To sum it up, index funds can operate at less than half of the cost that is incurred by mutual funds. This is the reason why even if the gross return offered by the index funds may be less, they offer better net returns than most mutual funds.

Tax Benefits

Mutual funds have infamously used window dressing. Most mutual funds buy high performing stocks at the end of the reporting period. This allows them to report higher returns. However, the incessant buying and selling of stocks leads to higher rates of churn. Each time stocks are sold, the gains are liable for taxation.

Hence, in the process of churning stocks, mutual funds end up paying lot more in terms of taxes compared to index funds. Since the proportion of stocks in index funds tends to stay relatively stable over time, there is less churn and hence the tax paid is significantly lower. This is another reason why mutual funds work out to be cheaper than index funds.

No Sales Side Push

There are many mutual funds in the market. Since they are all competing against one another, they have to employ the services of agents who help them to sell their units to investors. The problem is that mutual fund advisors tend to sell the funds which provide them the biggest commission. They are not really concerned with whether the fund will benefit the investor in the long term.

The good news about index funds is that they are relatively few in number. Most index funds do not use these salesmen to distribute the units. Since these funds are not aggressively sold, the chances of index funds being wrongly sold are relatively less.

Track Record

Lastly, the track record of index funds is relatively easier to scan. Investors only have to find out which funds most closely mirror the index and they can invest their money. This is opposed to actively managed funds wherein investors have to consider various variables before they are able to zero down on a fund where they want to invest their money.

To sum it up, index funds are simpler and have historically provided returns which are comparable to mutual funds.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

What is Cost of Equity? – Meaning, Concept and Formula

MSG Team

Cross Border Credit Reporting

MSG Team

What is Corporate Finance? – Meaning and Important Concepts

MSG Team