Index mutual funds are designed to mimic the performance of a particular market segment, such as the S & P 500 Index or the Lehman Brothers Aggregate Bond Index. The benefits of using an index fund in your portfolio are:
- Since the mix of stocks the index tracks is public information the specific mix of market allocations (e.g. large cap, value stock, growth stock, etc.) are well understood. There are no surprises or allocation drift.
- Index fund managers do not actively buy and sell stocks within the fund, but rather passively make trades to either add or remove stocks that are a part of the index they are tracking. Because of this, annual capital gains payouts are usually lower than actively managed funds and subsequently not taxed. This is termed –tax efficient.
- Since the investment goal of an index fund is well defined (i.e. track a particular market index) large, expensive research staffs are not required and the investment expenses associated with these funds tend to be much lower than actively managed funds. According to Morningstar, the average expense ratio of an index fund is about 0.49% versus 1.43% for the average actively traded fund. Over a five to ten year period that 1% difference is significant.
Here at Modular Financial Solutions, Inc. we make extensive use of index mutual funds as the core investments, as well as index ETFs to reduce investment expenses and improve risk adjusted performance.
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