Index funds refer to investment funds that use this type of management. The index fund or ETF (exchange traded fund) selects a group of securities that meets the investor's risk specifications. These securities are held in the portfolio for a fairly long period of time to minimise the transaction costs.
Using index funds doesn't remove the market risk but it does avoid the uncertainty that comes with active management as regards whether the portfolio managers will be able to outperform the market.
The main features of an index fund are as follows:
- They are easy to manage so there's no need for highly-paid managers, which makes them cheaper.
- The portfolio turnover is low so you can delay the tax on capital gains.
- They follow markets very closely rather than trying to outperform them.
Management that consists in mirroring an index or market allows for greater diversification in the investment portfolio, which in turn reduces the risk of the investment fund.
Passive management is particularly popular with small investors who have limited financial knowledge. In this case, there is no manager making decisions about which stocks to invest in because the idea is to simply follow the selected index.
The concept of passive management also includes funds or fund portfolios created with the aim of achieving a fixed return in a given period or a share in the return of an index.