Business

What's an Index Fund?

BY RANDY T ROWE

Sunday, June 30, 2019

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This week we're continuing the series on simple investment explanations. By now you must have heard about the latest IPO (initial public offering) coming from Sagicor — the Sagicor Select Funds IPO. This is supposed to be the first publicly listed Index Fund in Jamaica.

Let's find out what an Index Fund is. As always, we start with the simple, straightforward explanation. This week's topic, however, requires us to know two things instead of just one; an Index, and a Fund.

INDEX — In the world of stock markets, an index is a grouping of stocks based on some criteria they all share (yep, it really is that simple). Whatever the criteria are, any stock that meets those criteria qualifies to be a member of the index. This allows an index's movement to reflect the overall performance of those criteria in one place.

Again, in stock investing terms, indexes (or “indices” if you prefer the Latin pluralised version) show the performance of a group of stocks as a single number each day. The index is calculated and adjusted based on the overall value of each member company.

The bigger a company, the more it is able to move the index. This is called weighting and it allows the index to accurately show the overall effect of its member's movements.

Let's say a brand-new index starts out with a number of 100, and at the end of the first day of trading, the weighted average price of all stocks in the index went up by 10%. The index then would move up by 10% and its value at the end of that day would be 110 (100+10%=110%).

Here's a real world example to make it clearer.

The Jamaica Stock Exchange (JSE) currently maintains an 'Index' called The Junior Market Index for the companies listed on the Junior Market.

All 38 Junior Market companies are on this index. At the end of June 20, 2019, the Junior Market Index value was 3129.98.

Trading of Junior Market stocks the next day (June 20th) moved the overall value of Junior Market companies down by roughly -0.58%, so at the end of June 21, the Junior Market Index value was 3111.84 (3129.98-0.58%).

Often you will hear in the media something like either, “the Junior Market fell by roughly 0.58% today” or “The Junior Market Index moved down by 0.58% today”. Both things are the same and true. The Junior Market Index reflects how the entire Junior Market is doing. Indices can also be shown on a chart to reflect the changes over a longer time period. Now here is something key to remember; an index is just an indicator. You cannot buy an index directly. Think of it like a car's speedometer. It shows how fast the car is going, but you can't actually buy 100km/h.

Now the second thing we have to learn is about funds. Here's the simple definition for that.

FUNDS — A fund is a company created to hold and manage a group of assets purchased using pooled money. In terms of the stock market, a fund is a company that holds and trades a group of stocks bought on behalf of, and using pooled money from, that company's shareholders. Funds are often put together by investment banks (aka brokers) and then shares of the fund holding company are sold to anyone who wants to own a piece of the fund.

Now that we know both of these things, defining an Index Fund is as simple as putting them both together.

INDEX FUNDS — An Index Fund is a created by a company to hold and manage a group of stocks in a way that reflects the movement of an index. The stocks are purchased using money pooled together from the fund's shareholders. In the same way that an Index reflects the movement of a set of stocks, an Index Fund reflects the performance of an Index.

Simple right? It gets even simpler. Remember, how I said earlier that you can't buy an Index directly? Well, Index Funds were created to allow people who buy their shares to get results similar to the results of the Index.

So, let's wrap this one up and I'll throw in a some extra data as always. Stock Indexes (or indices) are indicators of the performance of a group of stocks. Indices cannot be bought directly. Want to get the performance of an Index? Then you need an Index Fund. Index Funds are designed to give their shareholders results similar to the movement of the Index that they track.

They have a few pros and cons, here are some.

Pros

1. Index Funds are diversified. They spread the money (and risk) out over multiple companies, thereby providing an additional layer of safety for investors. If one stock does badly, all the other stocks in the index softens the blow. This also allows you to benefit from multiple stocks though only buying one.

2. There's a theory (though not a law) that stocks always go up in the long term. This has held true for a few centuries, so it's been working out. Legendary investor Warren Buffet has encouraged regular people for years to simply invest in an Index Fund if they aren't experts. Most people who do this gain in the long term. If you aren't an expert but want a safer exposure to stocks, then Index Funds might be for you.

Cons

1. Index Funds have an additional cost than simply buying a stock directly. They often have a management fee though, it's usually low. (eg 0.5% of the fund's value each year).

2. The gains are limited because of the diversification. That's the price of diversification.

3. If the tracked sector crashes, the index crashes.

There are lots of details that Index Funds have that aren't covered here, but I hope this was enough to give you a general understanding of what they are and their pros and cons. The first listed Index Fund in Jamaica is coming July 3, give your broker a call to see if it's for you.

See you next week.

Randy Rowe is a Strategy Consultant and Lead Writer for www.everymickle.com. He is NOT an investment advisor. He's been trying to create his own “Bad Driving Taxis” Index for a few years now but the weighting has been giving him trouble. He isn't giving up, and neither are the bad driving taxis…


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