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The article will discuss how index funds are traded, how they are priced and potential issues investors may face when buying or selling.
Since index funds invest in underlying securities, the asset level of the fund can rise or fall with the value of those invested securities. The NAV price is also not affected by the public’s demand for the index fund. Every time a share is purchased by an investor, the fund company issues a new share. Therefore, even though the fund’s assets are growing with new money, the assets are diluted by the additional share prices that are issued. For more information on NAV, check out the article on “Understanding Mutual Fund Net Asset Value (NAV)”.
The same goes for when investors want to sell or redeem shares from an index fund. They can submit to either redeem shares or in a fixed dollar amount, and are still required to submit the order prior to the 4:00 p.m. cutoff. Any orders that are placed after the 4:00pm cut-off will be queued as a next day trade.
Meanwhile, index funds are relatively less expensive compared to actively managed funds because the passive strategy of index funds is designed to track a benchmark. Vanguard, for example, has several index funds that are passive in strategy, with an expense ratio that is 82% lower than the industry average. The Vanguard 500 Index Fund Admiral Shares (VFIAX), for example, is designed to mirror the S&P 500 and has an expense ratio of 0.05%. Although this fee is relatively low, the expense ratio is taken out of the fund’s NAV on a daily basis. For a more detail on mutual fund fees, read the “Complete Guide to Mutual Fund Expenses”.
In an effort to keep expenses low, many index funds like those offered by Vanguard use a technique called sampling or mirroring of the index. This is where the fund buys a smaller quantity in order to replicate the benchmark’s return. It would be far too costly to have to constantly buy and sell holdings to replicate the actual benchmark. For example, the Russell 3000 Index is comprised of 3,000 stocks and would be too hard for a fund manager to keep up. With this sacrifice, index funds may not have the exact same return as its benchmark. This difference between the fund return and the benchmark is called the tracking error. The lower the tracking error, the better the fund represents the benchmark.
This is extremely important for index funds because the fund’s goal is to mirror the benchmark. If the manager needs to liquidate in order to accommodate excess redemptions, it will further deviate from the benchmark and returns will suffer.
Another issue with selling securities under pressure of redemptions is that it may cause unintended tax distributions. When a fund manager sells an underlying security with a capital gain, those gains are passed on to the investor. One of the ways index funds help reduce excessive outflow is by having redemption fees for early withdrawals. This is designed to discourage investors who excessively trade in and out of the fund, leading to higher costs for the fund managers.
To learn more about index funds, check out our our Index Fund Center.
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