What Is an Index Fund: Fees, Risks, Investing Tips, & Hidden Index


What is an index fund?

An index fund is a fund that aims to generate a return that is as close as possible to a specific index. In practical terms, the fund buys the same shares in the same weights as the index you want to emulate. This is usually called passive management, as opposed to active management where a manager tries to create a return by making an active choice of shares.

Further explination of what an index fund is:

An index fund follows, just as it sounds, an index. An index is a comparative figure that describes how something develops, for example the stock market.

The fund invests in shares that are included in a certain index, and reflects its size in the index. In order for the fund to be able to “follow” an index, the holding therefore needs to be an exact mirror of the index itself.

If an index fund follows, for example, OMX Stockholm 30, which is the most common equity index in Sweden that reflects the return from the 30 most traded shares on the Stockholm Stock Exchange, this means that the fund consists of precisely these 30 companies.

This means that if Hennes & Mauritz constitutes ten percent of OMXS30, the fund will consist of ten percent Hennes & Mauritz shares as the fund also reflects the weighting in the index.

An manager of an index fund is therefore not tasked with finding shares worth buying, but simply follows the index.

Therefore, index funds to a greater extent have a lower management cost because the fund is not as complicated to manage as other fund types.

Index fund categories:

Some common categories in index funds are Global, Sweden, Emerging Markets, USA, Russia and Asia.

Index funds in the Sweden category follow the development for companies traded on the Swedish market.

Some types of these funds are broader and follow the entire Stockholm Stock Exchange index (OMXS), while others are slightly narrower and only follow the 30 largest Swedish companies in the OMX30 index.

Index funds in the Global category follow a global index, and then markets in countries such as the USA, Japan, Great Britain, France and Canada are often included.

Emerging Markets are called in Swedish emerging markets, and are characterized by markets whose economies are growing faster than the rest of the world for a long time.

Index funds in this category follow, as the name suggests, an index that includes countries classified as emerging markets. For example. China, South Korea, Brazil, Taiwan and Russia.

If you want slightly narrower types of index funds, you can choose, for example, the USA, Russia or Japan, which only target one market.

Why are index funds good?

Index funds are often highlighted as a good basic savings in a long-term portfolio.

The advantages that are highlighted are primarily that index funds are

  • cheap compared to actively managed funds
  • have low risk, as they follow a section of a market
  • Studies have shown that in the long run the increase in value in index funds is often higher than actively managed funds

The world’s most successful investor Warren Buffet himself has said on several occasions that small savers do best in investing long-term in cheap index funds.

Why the management fee in index funds is low

Since the purpose of an index fund is to constantly follow a predetermined index, much of the trading within the fund can also be automated.

This means that the fund manager does not need to have analysts and brokers working with the fund, which of course means that they do not have to pay salaries to them either.

For you, this means that the management fee will be significantly lower than for a fund that is actively managed.

Why it’s considered low risk when investing in index funds

If you are long-term in your savings, the risk in index funds is relatively low – but of course you need to review your index funds and keep an eye on the market in which the fund invests.

In recent years, the Stockholm Stock Exchange has risen by an average of around 7% annually, but year after year, movements are significantly more unstable.

Since index funds are primarily a long-term form of savings, you do not have to get too nervous when the stock market goes down.

History shows that the probability that it will increase again in the long run is high and since the index fund is intended to follow the development of the stock exchange, the value of your funds will also increase in the long run as the stock market rises.

Which shares are included in an index fund?

Which shares are included in an index fund depends entirely on which index the fund is set to follow – but usually the shares in the fund are based on the largest or most traded shares in a market.

How do I save in an index fund?

Most banks offer savings in an index fund via a fund account, endowment insurance or via an investment savings account.

If you do not already have any savings, the recommendation is to start an IRA either directly at your bank or at the broker of your choosing.

Then look up an index fund among the various funds and start saving, either as a lump sum or monthly.

What do hidden index funds mean?

Sometimes you come across the term “hidden index funds”.

This means an actively managed fund, which follows a predetermined index. In other words, the trustee charges for active management without managing it.

The result will then be a very expensive index fund.

How many index funds should you own?

The consensus among savings economists seems to be that a small saver does best in having somewhere between two to five different funds.

This makes saving easy to manage and easy to follow up.

If you then want to spice up your savings further, you can raise one or two top funds, which focus on emerging markets or specific industries.

When to buy index funds?

Personally, I save monthly in funds. In this way, I buy both funds in ups and downs.

For most people, it is a sustainable and simple strategy, because over time it evens out the peaks and valleys in price.

Is it always the same company that is included in a certain index?

No, if new companies are introduced on the stock exchange, these are included in the index (given that they are in the right industry or size).

Companies that are acquired disappear.

The composition of indices based on the size of the companies changes when a company has been on the “wrong” side of the specified size limit for more than a certain period, for example twelve months.

What is a stock index?

An equity index is a tool for measuring the price development of a certain group of equities. It can either include all shares on the entire stock exchange or different types of subgroups.

Common is a division based on the companies’ industry or size.

Most indices are weighted according to the market capitalization of the participating companies.

The change in such an index for a certain day thus consists of a weighted average of all the price shares’ price development on this day.

There are often two series of notes for a given index. On the one hand, a price index that only measures price development, and on the other hand, a return index that also includes the effect of the dividends paid by the participating companies.

The return index provides a more accurate picture, as it captures both changes in value and dividends. It then does not matter if a profit crown remains in the company or is distributed.

Equity index are provided by many different players, such as stock exchanges, stockbrokers and newspapers.

Conclusion

Can’t the so called finance professionals choose the best shares then?

The answer is no – they can not.

  • First, the professionals account for a large majority of all trading on the world stock exchanges. Since the stock market on average runs like the stock market, this means that for every professional who succeeds, there is another professional who fails.
  • And it is also not possible to look at which professional has succeeded historically. Research shows that funds that have performed well over the past three years do not fare a bit better in the future than funds that have performed poorly over the past three years. Either the good funds have just been lucky or they have found something smart that worked for a while, but that does not mean that it works in the future.

Sources

https://jpm.pm-research.com/content/28/3/31.short

https://onlinelibrary.wiley.com/doi/abs/10.1111/iere.12099

https://www.sciencedirect.com/science/article/abs/pii/S0378426609001496

https://www.tandfonline.com/doi/abs/10.2469/faj.v62.n4.4185

https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/abs/daily-momentum-and-contrarian-behavior-of-index-fund-investors/8AED06ABB6B59425F7DA3093F0D26E2A

https://www.tandfonline.com/doi/abs/10.1057/jors.1990.84

https://heinonline.org/HOL/LandingPage?handle=hein.journals/davlr53&div=31&id=&page=

https://www.sciencedirect.com/science/article/abs/pii/S0957417404001356

https://jpm.pm-research.com/content/27/4/45.abstract

https://link.springer.com/article/10.1057/jors.1995.139

Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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