Question

Index funds have become very popular in recent years. Discuss the features and benefits of index funds. Explain the reasons for their popularity.

Answer 1

Solution:-

Index funds have become the most widely used investment instrument for retail investors worldwide. It has been nothing short of an exemplary rise in popularity of index funds in the last couple of decades.

What are index funds?

Index funds are mutual funds that mirror an stock index in terms of its composition, therefore their returns mirror the returns of underlying index. In other words, an index fund that is based on S&P500 index would have its funds invested in the stocks that form S&P500 and in the same proportion which they hold in the index. E.g.: the proportion of index fund invested in Apple Inc. would be same which the Apple stock holds in S&P500 index.

Let's take a look at the features of index funds that make them so popular"

• Offers great convenience for retail investors as they don't have to worry about picking fund managers and can simply go for an index fund based on a major stock index
• They are based on the concepts of passive investing which is best suited for retail investors that don't have expert knowledge about financial markets
• Index funds offer great diversification to investors. All the major stock indexes are essentially a proxy of broader economy as they include all major sectors and major companies in those sectors. Thus, an index fund that is based on a major index also has its funds invested in all those major sectors and companies, thus offering great diversification to investors
• These funds are not managed by fund managers as there is no stock picking involved. The funds of investors are simply invested proportionately in the stocks of the underlying index. Due to this, the management fee of index funds are extremely low as compared to conventional actively managed mutual funds
• Promotes long-term investing for retail investors rather than short-term trading activities which are very risky
• The index funds are dynamic as they keep changing their stock proportions based on changes in the composition of underlying indexes. Therefore, if a stock is withdrawn from the underlying index by the stock exchange and a new stock is introduced, the index fund would also simulatneously withdraw its investment from the first stock and invest in the latter. Similarly, as the proportion of various industries and stocks change in the underlying index, the index funds also change their stocks proportions accordingly. Thus, at all times, the index funds are mirroring underlying indexes.
• The returns are based on broader economic performance and is not dependent on stock picking, thus acting as a great long-term strategy for retail investors offering stable long-term returns