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Index Funds, Unit Trusts or Individual Stocks – Part I

Warren Buffet made a bet a few years ago that index funds will outperform actively managed funds over a five-year period. He challenged anyone to pick five mutual funds and compared their five years’ performance against the index. Five years later, at his company’s annual general meeting, he showed the results of his bet. The index funds handsomely beat the aggregate score of the combined mutual funds.

Many observers have also noticed the trend of money flowing out of actively managed funds and into index funds as people realise the discrepancy in returns.

In light of these events, I thought it might be a good time to summarise the key advantages of the different investing options available to investors.

In this three-part series, I will look at index funds, unit trusts and finally managing your own stock portfolio.

Index funds

Index funds are passively managed funds that track the performance of an underlying stock index. In Singapore, there are index funds that track the performance of the Straits Times Index (SGX: ^STI).

Investors who invest in these funds are basically investing in a pool of stocks that mirror the index.

Key advantages

  • Portfolio diversity

When investing in an index fund, an investor gains access to a wide range of stocks. For example, the index funds that track the STI have a portfolio of 30 stocks listed in Singapore. These stocks cover industries ranging from commodities to telecommunications.

  • Low management fee

Unlike actively managed funds, index funds charge a much smaller management fee. Therefore, investors are more likely to reap better returns over the long-term.

  • Track record of beating actively managed fund

Index funds have been able to reap better returns over the long-term compared to its actively managed counterparts.

  • No need to constantly monitor the stock market

If you are investing in individual stocks and actively manage your own portfolio, you will have to constantly monitor each individual company. Fortunately for index investors, you do not need to monitor the stock market or individual company performances.

 Disadvantages

  • Cannot outperform the index

Unlike making your own investment decisions, or buying mutual funds, there is no chance that an index fund will beat the index as it merely tracks the index.

  • No control over investment decisions

Investors will not have any control over the kind of investments their money flows into.

  • Index funds may be overexposed to certain industries

Some indexes are not sufficiently diversified. The STI, for example, is heavily weighted towards the financial sector. If this industry suffers, the overall index will perform poorly.

The Foolish bottom line

Warren Buffett wrote in his 1997 letter to shareholders, “The best way to own common stocks is through an index fund that charges minimal fees.”

Index funds offer investors the ability to track the performance of the market consistently and at the same time, beat most actively managed funds. If you are looking for an investment vehicle that requires little monitoring and has a history of strong performance, then index funds may be the way to go.

Having said that, there are also disadvantages when investing in index funds. Investors need to note each of these before making an investment decision.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.