Fund picks and pans stocks

ஜº°Chloe°ºஜ says:

Advantages

Low costs
Because the composition of a target index is a known quantity, it costs less to run an index fund. No stock analysts need to be hired. Typically the expense ratio of an index fund is below 0.2%[citation needed]. The expense ratio of the average mutual fund as of 2002 is 1.36% [2]. If a fund produces 7% return before expenses, taking account of the expense ratio difference would result in an after expense return of 6.8% versus 5.64%.

Simplicity
The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one’s index fund holdings may be as easy as rebalancing every six months or every year. [2]

Lower turnovers
Turnover refers to the selling and buying securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometime passed on to fund investors. Because index funds are passive investments, the turnovers are lower than actively managed funds[citation needed]. The management consulting firm Plexus Group estimated in 1998 that for every 100% turnover rate, a fund would incur trading expense at 1.16% of total asset. [3]

Disadvantages of index funds

No Chance of Out-Performing
Since index funds achieve market returns, there is no chance of out-performing the market. On the other hand, it should not under-perform the market significantly. Investors should remember after all expenses and fees are subtracted their Rate of Return will not exactly be the market return of the index; however, it should be very close.

Owning a diversified stock index fund does not make an investor immune to systematic risk (e.g., a stock market bubble). [4] When the US technology sector bubble burst in 2000, the general stock market dropped significantly, and, as measured by the [S&P 500] index, has still not recovered.

The Objective To Minimize Tracking Errors Causes Losses
The stated objective of index funds (in their prospectus) is to minimize the tracking error as they follow the designated index. Whenever an index changes, the fund is then faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. As a result, the price of the stock that has been removed from the index tends to be driven down. The price of stock that has been added to the index tends to be driven up. These price changes tend to persist for 2-4 weeks.[citation needed] The index fund, however, has suffered permanent losses because they had to sell stock whose price was depressed, and buy stock whose price was inflated. All in all, however, these loses are small relative to an index fund’s over-all advantage gained by its overall total low costs.

Diversification
Diversification refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces the impact of a single security performing very below average. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not. [5]

Since some indicies like the S&P 500, and FTSE 100 are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.

Asset allocation and achieving balance
Main article: Asset allocation
Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor’s attitude towards investment risk and anticipated investment returns. Index funds can play an important part in selecting asset classes that conveniently reflect whole markets and can make up an important part of a balanced portfolio.

A combination of various index mutual funds or ETF’s could be used to implement such an investment policy. [3]

Comparison of index fund versus index ETF
Index funds are priced at end of day (4:00 pm), while index ETFs have intra-day pricing (9:30 am – 4:00 pm).

Some index ETFs have lower expense ratio as compared to regular index funds. However, brokerage expenses of index ETFs should not be over-looked.

US Capital gains tax considerations
U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains.

Scenario: An investor entered a mutual fund during the middle of the year and experienced an over-all loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the over-all loss.

A small investor selling an ETF to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.