What Is an Index Fund?

What Is an Index Fund?

November 2, 2021

If you are interested in diversifying your portfolio and would like to remain cost and tax conscious, index funds may be a great solution! The question you may be asking is, “What are index funds?”

Index Funds are portfolios of stocks, bonds and other asset classes. They are designed to parallel the makeup as well as the performance of a financial market index, such as the Standard & Poor’s 500 (US stocks) or the Barclays Aggregate bond index (US bonds). Another term for an index fund is passive fund where the goal is not to beat the index but to match it.

The role of a “benchmark” or “index” is a comparison for a portfolio and plays an important role in investment management. For example, a portfolio may be allocated 60% to equities and 40% to fixed income. An investment manager might assume 60% S&P 500 (US equity) / 40% Barclays Aggregate (US bond) as a weighted average benchmark for comparison purposes. It is equally important to select benchmarks that are the most representative of your portfolio composition and we at Sand Hill take many benchmarks or indices into consideration, not just US large company stocks and US bonds.

We view index funds as a very important part of an investing strategy, but we also believe that there is a time and place to incorporate some “active” managers. The objective of an active fund is to deliver performance in excess of a traditional benchmark. We use active managers to give our clients exposure to areas of the financial market that tend to be less efficient. This inefficiency is often driven by a lack of Wall Street coverage and/or a less understood part of the market. Active managers typically have a team of investment professionals who are selecting investments they believe to be undervalued.

There are several advantages to investing in a passively managed index fund to diversify your portfolio. The holdings are generally transparent as the holdings of at least the best-known benchmarks are widely reported. An index fund’s expense ratio—a component of every mutual and exchange-traded fund—is generally much lower than a more actively managed counterpart. Index funds are also generally more tax efficient than their active counterparts due to less trading within the fund (known as turnover).

To answer the widely posed question, “How easy is indexing?” in short, it is NOT easy. As with any fund, a well-run index fund has many moving parts. A good fund needs to be very liquid and charge a low fee. Some passive fund managers engage in activities such as securities lending that allows them to generate excess returns that more closely match those of the benchmark they track. The fund manager needs to allow for fund inflows and outflows without disrupting returns for existing shareholders. The fund needs to address corporate actions for the underlying companies and effective management of adding and dropping companies from the benchmark. For example, Standard & Poor’s will publish adds/drops from the benchmark every few months; an index fund must make those changes in a timely manner and work within the possibility of price changes of these stocks related to whether they are being added (increase in price) or dropped (decrease in price).

At Sand Hill, we incorporate both passively and actively managed strategies within your portfolio. If you are interested learning more about index funds, speak with a Sand Hill Wealth Manager today.

Articles and Commentary

Information provided in written articles are for informational purposes only and should not be considered investment advice. There is a risk of loss from investments in securities, including the risk of loss of principal. The information contained herein reflects Sand Hill Global Advisors' (“SHGA”) views as of the date of publication. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. SHGA does not provide tax or legal advice. To the extent that any material herein concerns tax or legal matters, such information is not intended to be solely relied upon nor used for the purpose of making tax and/or legal decisions without first seeking independent advice from a tax and/or legal professional. SHGA has obtained the information provided herein from various third party sources believed to be reliable but such information is not guaranteed. Certain links in this site connect to other websites maintained by third parties over whom SHGA has no control. SHGA makes no representations as to the accuracy or any other aspect of information contained in other Web Sites. Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. SHGA is not responsible for the consequences of any decisions or actions taken as a result of information provided in this presentation and does not warrant or guarantee the accuracy or completeness of this information. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without the prior written consent of SHGA.


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