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Index Funds: Advantages and Disadvantages

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Index funds are quite possibly one of the most famed financial instruments in the world of investing. Their simplicity is a big part of their claim to fame. When we combine this with their generally reliable expectation for decent returns, the result is a staple utilized by portfolios worldwide. 

Like almost any investment vehicle, though, index funds still bear their fair share of both pros and cons, and investors can’t afford to ignore either side of that coin. So before adding an index fund to your portfolio, it’s worth taking the time to investigate the fine print. Luckily, we’re about to get down to brass tacks for you. 

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A little perspective on index funds

The concept of an index fund is relatively new in the bigger picture. Its origins date back to around 1960, when two college students from the University of Chicago first coined what they imagined as an “unmanaged portfolio“.

The idea didn’t exactly catch on at first, but it did get the ball rolling, and eventually, the first official index fund was created back in 1975 by John Bogle, just a year after he had founded The Vanguard Group. The fund then bloomed from just $11 million in assets to over $827 billion in 2021, as it continues to be one of the most popular funds today. 

The inner workings of index funds

Index funds are fairly simple in theory. For example, they pool the assets invested in buying shares of the stocks contained within a particular index, like the S&P 500. The end result is typically a naturally diversified portfolio, or at least more so than buying individual stocks. 

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Index funds are mutual funds, but not all mutual funds are index funds. They differ from other mutual funds types, which are more often than not actively managed funds with higher fees that attempt to derive higher returns as a result. In contrast, index funds are much lower maintenance, just aiming to track the performance of an aggregate index. 

They also depart from their close relative, ETFs, in a couple of ways as well. Firstly, index funds often require a higher minimum investment than their stock-like counterparts. Secondly, ETFs can be traded throughout market hours like ordinary equity, whereas index funds are only bought and sold at a settled price when the trading day closes. 

Index Funds: Advantages & Disadvantages 

All investment vehicles are tailored to fit specific criteria, for certain goals, for investors with particular preferences. With that in mind, it might be fairer to look at their subjective “cons” as simply part of their nature and not necessarily shortcomings of their intentional design. 

Have a closer look at some index funds pros and cons.

Index Funds Advantages:

Passivity: Passive funds have certain benefits over actively managed alternatives. Most obviously, this means lower fees for investors, but it also means more openness and transparency. 

Consistency. Index funds can be less subject to the sometimes wavey beta that can hit individual stocks at times. This is partially due to their diversification but also simply because an index as a whole is less likely to experience dramatic moves than a single stock or more active funds. Although nothing is known in the market, historical data oftentimes (not always) tells us this also leads to more predictable returns, which is a desirable trait for most long-term investors. 

Performance. We account for both their reliability and consistency when evaluating the performance of index funds. Still, something else that can’t be overlooked is that historically speaking, index funds may outperform most actively managed funds. 

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Index Funds Disadvantages:

Inflexibility: As mentioned above, some of the index funds’ cons might be part of their nature. Index funds were built to mirror an Index, and as you might know, there isn’t an unlimited number of indexes out there. So, they weren’t built to be that customizable and may not be well-suited for investors who would prefer some more customizability in their portfolio. Be that as it may, their inflexibility could still very well be a drawback for those who prefer more personalization.

Capped upside: While index funds are often reliable and consistent, they also have a relatively limited upside as well as negative results. They’re certainly not penny stocks or crypto, and you won’t be seeing any 2-10x returns without some great amount of patience. Is this a disadvantage? For some investors, perhaps, but for others, they may prefer something that’s oftentimes (but not always) less volatile. 

Bottom Line 

Almost all investment vehicles are built to suit a specific need or do a particular job for those who utilize them. Index funds are a perfect example of this, and both their shortcomings and their advantages are interwoven into their nature by design. 

So, with that in mind, one of the most necessary steps in evaluating whether or not index funds are suitable for you is first to take stock of your own investment style, risk tolerances, long term goals, and financial situation as a whole. Every individual situation is unique, and each investor brings their own needs and preferences to the table. Index funds could be an excellent tool for many, but it’s invaluable to first decide for yourself.

Index funds or not, keeping track of all your portfolios is a seemingly never-ending battle for all investors, especially if you’re the organized type. Fortunately, Front can help with that exact problem by allowing you to track all your holdings in one place and provide you with some insights, too, via the Front Score. 

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