Bob Brinker's Marketimer

  Monday November 20, 2017

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ADVANTAGES AND DISADVANTAGES OF INDEX SHARES
Learn even more about this topic with the Encyclopedia of Personal Finance™

Index shares, like index funds, provide investors with several advantages. For both, the main attraction is diversification made easy. Perhaps the most basic rule of investing is not to put all of your eggs into one basket. Suppose you invest all of your money into a hot Internet stock that later becomes entrenched in a lawsuit or fails to keep up with new technology. You would risk the possibility of losing money because you failed to diversify your portfolio. By buying an index share or index fund, you are buying a small piece of many companies representing a variety of industries, thus lowering the risk of your portfolio.

With both index funds and index shares, diversification is easy and cost-effective. With only one transaction (and one transaction fee), you can own a diversified portfolio. Because these investments track an index, their price and performance are widely reported and easy to follow.

An index fund, however, is a type of mutual fund—you buy and redeem shares by dealing directly with the fund management company. Index shares, on the other hand, are bought and sold on the secondary market and behave more like stocks. The following highlights some of the principal differences between these two investments and points out some of the pros and cons of each:

Liquidity: Investors can buy and sell index shares at any time during trading hours, providing them with the possibility of taking advantage of market rallies and avoiding sell-offs. In contrast, index funds only allow investors to buy or redeem shares using the price at the end of the day. In some cases, index fund investors are required to mail in their requests for trades, thus further delaying their execution.

Tax considerations: Capital gains taxes are paid on index shares when you decide to sell your shares. By contrast, index funds distribute capital gains dividends once a year, which requires you to pay taxes on those gains.

Costs: Both index shares and index funds are relatively cost-efficient: because they do not need to be actively managed, management expenses can be low. However, because you will need a broker to buy and sell your index shares, you will be charged a commission on each transaction. Both index funds and index shares will deduct management costs from your distributions as well.

Dividend reinvestment: Index funds allow investors to reinvest their dividends to buy more shares in the funds. Index shares must distribute their earnings to shareholders. The shareholder generally must buy new shares on the market if he or she wants to reinvest, incurring transaction costs in the process.

Now that you are familiar with how index shares function, let's take a look at an example of one such investment. Here come the Spiders!




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