Index funds - Part 2
Last week we look at what an index fund is. This week we’ll take a look at how you can diversify your investments in index funds and some of the pros and cons.
By Viktor, co-founder of Bifrost - Feb 11 2019
Different index funds
By choosing which index funds you want to invest in, you can easily choose which markets you want exposure to. Perhaps you have a feeling that the United States is on the rise and you want to expose yourself to their stock market without putting any time into getting acquainted with different industries or companies. For example, an index fund that follows Nasdaq can be good to look at. Nasdaq has a lot of different indexes where you can look at specific industries. Then there is also an index in the US called S&P 500, which contains the 500 most traded companies in the country. This provides a very comprehensive picture of the entire economy's development in the United States.
Good and bad with index funds
If we look at the advantages and disadvantages of index funds, it is about time to highlight the cost-effectiveness as one of the advantages. Some are even free. They are not actively managed like an equity fund and thus have lower costs for the bank. Many banks offer these index funds for free to bring in new customers with the hope that they will eventually lose patience and want to grow their capital faster than possible with index funds and start investing in some of the bank's actively managed funds.
Another advantage of index funds is transparency. An index fund is very simple, not to say crystal clear when it comes to you as an investor to see if you got the right price development for your money.
However, an index fund can look rather boring from an investment perspective. Take for example the FTSE 100. Here are the 100 most valued companies are included. These companies have been on the stock exchange for many years. It is unlikely that some of these companies will do anything revolutionary that will make the course soar. Instead, they will probably be quite stable. They will make reasonable dividends and invest gently. Companies that are young, innovative and who can present ideas that for stock markets to go up 60% in a week do not exist here. In the long term, they can be there, but then the market has already taken part of that upswing and when the company ends up on the FTSE 100, it is a mature company that just like its index siblings will have a fairly predictable time on the stock exchange.
Finally, it may be good to be cautious about the weight of the various companies in an index. OMXS30, for example, which is the main index in Sweden, had 40% of its weight in Ericsson in the early 2000s. This means that the index becomes very dependent on how it goes for that particular company. This undermines the purpose of the index, which was to reflect the entire stock market or to provide a cross-section of the stock exchange, market, or industry. This directly affects index funds whose idea is to follow the index.
If you believe in the stock market as an investment platform over time, but you want to sit back and relax - then it may be time to take a closer look at index funds.