INDEX FUNDS

Meaning of Index Funds

Dictionary

The mutual fund family has had one member richer for several years. In addition to traditional equity funds, index funds are becoming more and more popular. Index funds were only approved in Germany when the 3rd Financial Market Promotion Act came into effect in 1998. Before that, fund companies were prohibited from replicating an index within a fund. The majority of the index funds are set up as Exchange Trading Fund (ETF). This is a fund that is not issued by the capital management company with a premium, but rather a listed security. At the beginning of 2010, 550 index funds were registered with Deutsche Börse and had an investment volume of 120 billion euros.

  • Index funds are passively managed funds.
  • The fund replicates a stock index, for example the DAX 30 as closely as possible.
  • Apart from the issue surcharge, funds are subject to all sorts of other fees.

How an index fund works

Index funds are passively managed funds. While the fund management of a conventional equity fund continuously monitors the investments and is constantly looking for alternatives, this task is not necessary with an index fund. The fund replicates a stock index, for example the DAX 30 as closely as possible. The fund manager only has to intervene if there are changes in the composition of the index itself. However, index funds do not hold the entire index in their portfolio, but also rely on derivatives or mix in one or the other shares not listed in the index. The extent to which these deviations are permitted can be found in the fund prospectus.

The performance

Supporters of traditional equity funds with active management miss the ability to intervene in certain situations with index funds. If a share is significantly undervalued, the fund manager cannot include it in the fund and thus replace another security because it then no longer meets the quota for the individual stocks in the index. Interestingly enough, index funds perform at least as well as actively managed funds. These are always looking for comparison with an index. A global equity fund, for example, uses the MSCI World Index as a comparison. Often enough, however, these funds lag behind the index. The tracking error is used as a key figure to measure the success of an index fund. This code shows how big the gap between the index fund and the index actually is. The smaller the number, the more successfully the fund management worked.

The cost of an index fund

In addition to the very good performance of these funds, they offer investors two other pluses. Apart from the issue surcharge, funds are subject to all sorts of other fees. The management fee in particular, the fee for fund management, is definitely noticeable. However, the management costs for passively managed funds are significantly lower than for the actively managed variants. The second plus point is the lack of a premium. ETFs are traded on the stock exchange, so there are brokerage and brokerage fees for the bank. Investors who opt for a broker who waives a brokerage fee based on the order value and charges a flat fee, a fixed fee that is independent of the volume, can save a lot of money in this case.

Sample calculation

The calculation example illustrates the advantage: An investor buys a conventional fund for 10,000 euros, the premium is five percent, i.e. 500 euros. Another investor buys an ETF for 10,000 euros; the brokerage fee for the bank is 0.25 percent of the order value plus expenses. He pays at least 25 euros. The third investor trades an ETF through a broker with a flat fee of 4.95 euros in Xetra. The savings are serious.

INDEX FUNDS