ADVANTAGES AND DISADVANTAGES OF INDEX SHARES
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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