Finding the Right Index Funds

Reviewed: February 03, 2015
By FinanceWeb

Index Funds Offer Advantages

Investing in index funds is a basic and sound approach. These funds have performed well in comparison to actively managed funds, and they can balance a portfolio. A well-balanced portfolio can achieve investor goals with the minimum possible level of risk. The difficulty is in selecting a grouping of stocks that meet the intended investment strategies. There are several thousand funds from which to choose, and within groups that have common indexes, performance may vary widely. Investors must balance the strengths and limitations of these funds in terms of their investment goals. While investors sometimes assume that all funds provide a wide exposure to the market, some funds are narrowly focused and have similar vulnerabilities as individual issues of stocks. Broad-based indexes can provide a hedge against volatility but may not capture the market involved in the investor’s strategy. For example, one may wish to emphasize solar energy stocks by buying an energy-based indexed fund. The scope may be too broad, and one must refine the search to find funds that give the desired weight to solar energy.

Diversification

The important safety guard against market volatility is portfolio diversification. This arrangement provides the best protection against losses from particular market events and trends. Diversification includes a global scope. For example, in India one could note high rates of savings and investment and examine indexes based on medium and small securities and financial services firms. The selected index is narrow, and it seeks to capitalize on rising investment among the expanding India middle-class. However, the scope of the selection search is broad; it has a global scope.

Selecting Indexes

Many indexes appear to be broader than in fact they are. When fund managers weight the underlying basket of assets in a particular business area, the investment may be prone to volatility despite the size of the index. The broad indexes such as the S&P 500 have distinct biases or weight towards certain sectors or investment type such as high cap companies. One can guard against volatility by selecting funds that complement each other. The Russell 3000 has a weight or bias favoring large U.S. corporations and is distinct from the S&P Aristocrat indexes that consists of stocks that have paid dividends over several decades. One can add indexes that emphasize profits to those which emphasize equity.

Flexibility is Vital to Long-Term success

The market is unpredictable, and any set of investments can take disappointing turns. A fund can behave like other stocks or instruments particularly when narrowly focused on a sector or an area within a business sector. When considering a portfolio for cause like poor or disappointing performance, one can determine the current high-performance indexes. They may be outside the investor’s past range of stocks or bonds; they may be high performing funds consisting of REITs or ETFs.

Planning in Advance

When assessing the performance of a portfolio one will have choices. It does not have to be a matter of the moment; one can form ideas well in advance. Many thoughtful investors do this as a matter of habit, and taking mental notes and impressions is a fine way to keep abreast of the market and to develop a strategy. Some investors do this whenever they purchase funds; they consider alternatives and other investment methods for achieving goals. Some principles can guide investors under nearly every circumstance. For example, high-income investments need not wait until retirement. Some view profits as an opportunity, and one that can be used whenever available. For these investors, cash infusions from profits increase investment flexibility.