Here’s a back-to-basics posts for those who are confused about the benefits of index funds. If you’re already familiar with the benefits and drawbacks of this type of investing, feel free to move on. If you haven’t been keeping up with my jargon, this one’s for you.
It’s less risky. An index fund adheres to rules and standards regardless of the state of the markets. Designed to track and/or match the components of a market index, the fund provides broad market exposure, meaning low operating cost and low portfolio turnover. This broad exposure means you eliminate the possibility of human or manager-related risk; underperformance will not come as a result of mismanaged funds.
You can do so at a lower cost. Index funds have dramatically lower costs than actively managed mutual funds. This eliminates the need for labor, as well as well-commissions and bid-ask spreads–fees that might come from high turnover generally experienced in actively-managed funds. Additionally, you will spend significantly less tie selecting and monitoring your portfolio, and–quite frankly–time is money.
It’s more tax-efficient. Lower turnover means fewer capital gains distributions, especially in a broadly diversified index fund. Minimizing capital gains will streamline your tax process. Additionally, the lack of need to change funds every few years (when a fund manager may retire) helps to minimize capital gains. If your capital gains grow significantly, your tax process will become very complex—you may need to hire a professional or download software to ensure accuracy.