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What is index funds?

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There are some investors who are concerned with the costs of investing into mutual funds or unit trust. The main bug bear is the annual management fees which runs into 1.5% or higher. This causes the returns of an investor to be reduced and so it will take longer for an investor to earn an adequate return on the investment.

So is there a way to have something almost like a mutual funds with low management costs? Yep, it is like a Coke Lite- with the essential ingredient of Coke, but not as bad on the sugar count. This is what is commonly called an index fund. This index fund tracks well known indices like the S&P 500, the FTSE, Russell 2000 which tracks the small cap stocks in the US market index. There are a lot of index funds out there that broadly tracks the movement of the market. So what they do is they look at the companies that make up these index and their weightage and they will buy shares of companies using these weightages so that the fund mirrors the index.

An investor that puts money into an index fund, basically feels that the normal funds are too expensive to invest in and thinks that most fund managers cannot beat the market. So how true is that opinion?

Under Efficient Market Hypothesis, it states that the market prices of traded assets like stocks, bonds etc reflects all the known information. So if a market is strongly efficient, it means that there is no arbitrage opportunities and so no one can earn excess returns (ie fundamental analysis no longer works in a strong form efficient market). So if that was true, a chimpanzee throwing darts at the stocklist page will do as well as a fund manager choosing the stocks. Thus, an investor who does not believe that the fund manager will do well enough to beat the market will want to invest in index fund just to diversify and know that the costs is low as the fund basically just tracks the underlying index so they do not have to hire fund managers or analysts to look at the stocks.

So you need to consider which is for you. Do you believe that there are no one who can consistently beat the market and the market is efficient or do you believe that there are inefficiencies in the market that can enable some people like Warren Buffet to make a lot of money using methods like value investing.

Often times, you find that investing is like a balance of Yin and Yang. You need to decide which one you believe. For myself, I am invested in both an index fund and also a normal mutual fund/unit trust, as well as stocks and share. For beginner investors, I would advise that you buy an index fund as you get the hang of all those different funds out there and monitor them for a while before you actually buy one which is managed.

This is a good article on this topic of index funds.

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