Smartest investment and life plans in UAE

An Overview of Low-Cost Index Funds' Investment

By PolicyBazaar

Invest smart today for a better tomorrow

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Published: 04 June 2020Last Updated On: 20 January 2021

Smartest investment and life plans in UAE

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While you start moving towards building your wealth by mutual fund investment, you may get confused about which one you should choose- a passively managed mutual fund or an actively managed one.

As per research, only 10 mutual funds that are actively managed out of 10,000 have been able to beat S&P 500 over the last 10 years consistently. The history shows that only a few of such funds will be able to manage this same thing in the coming 10 years.

The solution is easy- until you are not sure that you can select this 0.001% of these mutual funds, which may beat the market, the best thing to do would be making an investment in the market itself.

S&P 500 represents this ‘market’, so basically you would be investing in the mutual funds, which duplicate the holdings of S&P 500.

This strategy can be taken a step ahead by starting a dirham-cost averaging scheme into index funds that involve low-cost. By using this plan, you can make sure to out-perform most of the managed funds in the long run.

The financial experts advocate that the individuals who are not willing or are incapable of effectively evaluating individual stocks must put their money in low-cost index funds.

Now, the question here is, why should they invest in such funds? The answer is clear in the three different advantages these index funds have in comparison to the actively managed ones.

  • The low-cost index funds hold almost negligible expense ratios, offering a considerable competitive space against the actively managed tools. The former mostly ensure a superior performance in the long-term.
  • They do not need any corporate analysis or any kind of understanding in terms of accounting, portfolio policy, or financial theory.
  • They huge number of companies. Such a diversification causes a reduction in the company-related risk. 

What do you mean by Index Funds?

Before including index funds in your portfolio, it is necessary to know what they exactly are. Index funds refer to mutual funds, which are designed for mirroring the performance of any of the main indices in the market.

In the case of mutual funds that are actively managed, the portfolio managers analyze, evaluate, and acquire each stock, whereas, index funds are managed passively. This means that they include a group of stocks (which is pre-selected), that almost never changes. 

Skipping the Financial and Corporate Analysis

Index funds are suitable for the people who do not know how to analyze competitive advantages of different corporations, know the exact difference between a company’s income statement and its balance sheet, or correctly calculate cash flows.

Since risks that are specific to corporations are diversified away due to the large number of companies, which are a part of all the main indices, there is no need for any such analysis. Moreover, index funds are a cost-effective method of acquiring a huge number of stocks at the same time avoiding spending thousands of dirhams in brokerage fees that may otherwise give results. 

Use the Lowest Expense Ratios on Mutual Funds to your Advantage

The individuals holding actively managed funds have to pay their analysts, portfolio managers, fees for research subscription, and more. The expense ratio is the percentage amount of the total expenses of the funds including the charges divided by the net average assets involved.

Since index funds need no such management and do not involve any of the above-mentioned charges, the expense ratio remains almost zero as opposed to an average mutual fund. This means that a lesser amount of the investor’s money will be spent on paying compensation, sales charges, and overhead. In the long term, the lesser costs involved in index funds may lead to improved performance. 

In a Nutshell!

Index funds are potentially a worthy financial tool, which can help you save a huge amount of money and assist you in getting a good foundation. After you earn enough to get some real funds behind you, think about having the underlying components and moving on from the pooled structure completely.

If you have been thinking about the downsides against the advantages of an index fund, then remember that these funds are neither your friend nor your foe. They are simply a tool. Make an investment in them only when it is ideal for you or it will be advantageous for you.