Index fund

Diversification
Main article: Diversification (finance)
Diversification refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not.[8]

Since some indices, such as the S&P 500 and FTSE 100, are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.

Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization [9]. A global indexing strategy may outperform one based only on home market indexes because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.


[edit] Asset allocation and achieving balance
Main article: Asset allocation
Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios.

A combination of various index mutual funds or ETF's could be used to implement a full range of investment policies from low risk to high risk.


[edit] Comparison of index funds with index ETFs
In the United States, mutual funds price their assets by their current value every business day, usually at 4:00 p.m. Eastern time, when the New York Stock Exchange closes for the day.[10] Index ETFs, on the other hand, are priced during normal trading hours, usually 9:30 a.m. to 4:00 p.m. Eastern time.

Index funds tend to have higher expense ratios than ETFs.


[edit] U.S. capital gains tax considerations
U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains.

Scenario: An investor entered a mutual fund during the middle of the year and experienced an overall loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the overall loss.

A small investor selling an ETF to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.