What is Indexing?
Indexing is an investment strategy of "passive" management to match the average performance of a stock market index, a particular underlying market segment or group of stocks. Usually, "buying a market" or replicating an index accomplishes this.
Indexing offers lower risk with diversification as money is spread over the entire market. It also eliminates the risks, costs, and uncertainties of "active" management (stock picking and market timing). Remember, the major role of an index fund manager is not to pick stocks actively, but to ensure the fund's portfolio tracks the chosen index closely.
Index investing is perfect for novice investors who just want the benefits of stock ownership without either the hassle or the risks that are inherent in picking their own stocks.
Index-tracking Funds - The Limitations
The constraint of passive management would be in times of falling markets, as the portfolio cannot be adjusted freely and the fund manger cannot move into cash to protect the fund. Nor can the fund be expected to outperform the market during boom periods.
Another risk is tracking error. It occurs when the performance of the fund varies from that of the index, which it is supposed to replicate. It is because the portfolio may not perfectly replicate the index. Also, an index does not incur transaction costs, subscription charges and management fees, but a real portfolio does. Moreover, liquidity and low trading volumes of the market that the fund invests in can lead to returns that don't match that of the market.
An Alternative to Index-Tracking Funds
An alternative to index-tracking funds is Exchange Traded Funds (ETFs) that tracks an index. Unlike open-ended mutual funds, ETFs are traded, like individual stocks, on an exchange throughout the trading day. They do not levy subscription or redemption charges, but investors must pay brokerage fees and normal transaction levies to buy and sell ETF shares, as well as annual management fees. The Tracker Fund of Hong Kong is a typical example.
The trading value of the ETF is based on the net asset value of the underlying stock portfolio. Due to the low portfolio turnover and passive investment characteristic, ETF has an expense ratio lower than other actively managed funds. Visit Boom's Global ETF Center for more information!
This article is offered for educational purposes only. Monex Boom Securities (HK) does not recommend specific investment products. Make sure you fully understand any investment product before investing to determine whether it may meet your needs.