Question

explain why investors should invest in low expense index funds rather than popular mutual funds managed by well-known money managers with additional expenses

Answer 1

Index funds can be defined as the equity based funds that invest in the stocks that the particular index tracks.The index funds are passively managed , stability providing investment vehicle.These days the low expenses index funds are gaining popularity in the investment sector over the traditional mutual fund investment because of the various advantages they offer. Let us have a look as to why the investors should invest in low expense index funds rather than popular mutual funds -

1. Diversification- Index funds provide concentration of risks in extremely diversified security. One has not to worry about concentration risk and that the particular security within which the risk is concentrated is not working. Even if one security does not work the others may perform well.
2. Exchange traded funds: The problem associated with the normal mutual fund is that it can only be bought and sold at the net asset value declared at the end of the day. Whereas the index funds which are traded on exchanges can be brought and sold anytime of the day at the market price. There exists absolute price advantage in the index funds which is otherwise unavailable in the non exchange traded mutual funds.
3. Cost effectiveness- As the portfolio is based on a particular index of equity so this means that there is lesser churning of the portfolio as compared to the mutual funds with popular backgrounds being managed by the well-known money managers. This results in additional expenses which in turn increases the cost of the portfolio management. There is saving on the brokerage cost and the transaction cost which in turn is in benefit of the investors. Since the role of fund managers is strictly limited, the fund management charges are very less. The major expense is cut down in the index funds as a result of which the expense ratio goes down to a really low level as compared to the popular mutual funds.
4. Tax effectiveness- This may be cited as one of the biggest advantage of opting for Index funds over the mutual funds. Since the index funds provide lower turnover this contributes to make it really tax efficient. The returns earned on other mutual funds is really taxing. Therefore it may be called prudent to invest in these kind of index funds over the actively managed mutual funds.
5. Risk effectiveness- Since the Index funds are managed by passive style of management, the risk associated with the fund manager quitting the fund or taking wrong investment calls during the period of investment to a certain level is reduced to almost zero.Thus, the only risk that the investor has to deal with is the market risk.
6. Easier to manage- Since the investors have not to bother about the performance of specific funds they enjoy management flexibility. The investor just have to balance and manage their portfolios on a periodic basis
7. Global market efficient- as the market starts growing and becomes more and more efficient, it gets harder and harder for funds to perform well. In such a scenario the investors prefer to invest in passive funds like index funds.