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3 Things You Need to Know About Index Funds and ETFs

By Divyansh Awasthi – Jul 1, 2020 at 5:16AM

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These three functions may bolster your decision to add some ‘passivity’ to your portfolio.

Those of us who have invested directly in stocks know very well the sense of anxiety that comes along with it. Though we all know the importance of patience and perseverance when it comes to equities, they tend to go out the window once markets start tanking. And there is another challenge: You can buy only a limited number of stocks with a given amount of money, and most of us have only a limited amount of money to invest.

These two concerns can be easily addressed by instruments like index funds and Exchange Traded Funds (ETFs). Other investing options, such as mutual funds and some ETFs, are actively managed -- meaning that their portfolio composition keeps changing frequently. For our purpose, we will focus on index funds and index-tracking ETFs. They represent what is technically known as passive investing. Why passive? Because unlike a typical, actively-managed mutual fund, these two instruments do not change their portfolio a lot. They simply mirror an index, like the S&P 500, and their portfolio constitution changes only when the composition of the index does. For example, an ETF like SPDR S&P 500 ETF (SPY -1.68%) will comprise the same number of stocks and in the same proportion as the S&P 500 index. These funds attempt to mimic the returns of the index they are mirroring.

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Among a plethora of functions of passive funds, there are three that are vital for you to know.

Function One: Investment discipline

Investing is a fruitful activity in the long term. To be successful, discipline is vital -- yet very hard to implement. This is where passive vehicles like index funds and ETFs can help. Remember the anxiety that we talked about earlier? That can easily lead to you selling a falling stock and trying to ride the coattails of another which seems to be rising. This kind of reaction is too short-term and will never lead to any worthwhile gains for your equity portfolio.

Enter passive funds. Because they mirror indices, their returns are usually not as volatile as individual stocks. By reducing your exposure to volatility, which can lead to hasty, anxiety-induced trading decisions, this feature automatically curbs your urge to sell. Further, any small adjustments made to the portfolio in order to keep it in sync with its index are done in the background, so you don't need to worry about managing your own investment. And lastly, the passive nature of index funds inherently provides discipline since their portfolio is not changed too frequently. Indirect, but does the job.

You can also make use of a Systematic Investment Plan (SIP) to further ensure discipline. This helps you invest a defined amount into a chosen fund every month. Once you sign up for it, you know you have to set aside a part of your income for this auto-debit facility. This may sound coerced but is very effective.

Function Two: Portfolio diversification

There are many of us who unknowingly indulge in portfolio concentration. This means we have most of our money invested in a single stock, or stocks from the same sector or industry. When that stock or sector performs well, such a portfolio benefits immensely. However, a slump can severely damage returns and again lead to anxiety.

Index funds and ETFs easily solve the dual problems of anxiety and portfolio concentration. Because these funds track an index, they are invested in tens or hundreds of stocks. Each dollar that you invest in these instruments buys you a small portion of all the companies they are invested in. Spreading your money across stocks from various sectors is known as portfolio diversification.

Because of the large number of holdings, a fall in one stock, industry, or sector does not impact the entire fund or ETF as much as being invested into a single stock.

Let's take an example. An investment of $9,000 in Marathon Petroleum (MPC -4.72%) at the beginning of the year would have declined by over $3,700 as of June 26. However, the same amount invested equally, i.e. $3,000 each, in a portfolio of three energy sector stocks, Marathon, Chevron (CVX -6.53%), and The Williams Companies (WMB -6.45%), would have fallen less -- by about $2,700. That is the benefit of diversification in a falling market, and passive index funds offer this benefit to the tune of hundreds of companies at once.

Function Three: Avoid market timing

Trying to get in on a stock at the 'best time' and exit at its peak is a compelling temptation. But even seasoned investors know that it's best to stay away from timing the market.

Passive funds help keep your investment automatically diversified and you remain disciplined, eliminating the need for market timing. Market volatility balances out over the long term, and consistent investment reduces the need to buy or sell continually. Therefore, investing in index funds or index-tracking ETFs reduces your urge to find the best times to invest or redeem.

The SIP approach can be beneficial here as well. Much like the first function, SIPs will force you to invest at consistent intervals, thus eliminating the temptation to time the market.

Test the waters

Passive funds are a great way to test the waters of equity investing. They can help you build a core portfolio and watch how it performs as you learn more about the stock market. If you like a bit of risk but not too much, these funds can be where your buck for equity investing stops. However, for more adventurous folks, passive funds can form a stepping stone into direct equity investing. Regardless of your love for risk, these three key functions might be just what you need to become a bit ‘passive’ with your portfolio.

Divyansh Awasthi has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Chevron Corporation Stock Quote
Chevron Corporation
CVX
$144.77 (-6.53%) $-10.12
The Williams Companies, Inc. Stock Quote
The Williams Companies, Inc.
WMB
$29.15 (-6.45%) $-2.01
Marathon Petroleum Corporation Stock Quote
Marathon Petroleum Corporation
MPC
$91.45 (-4.72%) $-4.53
SPDR S&P 500 ETF Trust Stock Quote
SPDR S&P 500 ETF Trust
SPY
$367.95 (-1.68%) $-6.27

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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