Index Funds Explained

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You may have already heard that Sagicor Investments Limited has launched its Initial Public Offering (IPO) for the Sagicor Select Fund. This select fund is actually an index fund consisting of stocks in the financial and insurance sectors.

But, what is an index fund?

What Is an Index?

An index consists of items that share similar characteristics or features. So, any item that matches the criteria for the index would be part of that index. For the stock market, the index would consist of stocks that belong to the same category. The Jamaica Stock Exchange currently has six indices that consist of different mixes of the listed companies on the market. An index may add new stocks or remove existing stocks if they meet or fail to meet its requirements.

Another thing about an index is that its performance is calculated and presented in a single number. So you may have heard news of an index advancing or declining at the end of the trading day. That is based on the calculations of the value of each individual stock within the index at the end of the day’s trade. However, it is possible for larger companies within the index to influence the movement of the entire index.

You cannot buy an index directly as it is only an indicator of the movement of the different stocks within it.

So, let’s define a fund.

What is a Fund?

A fund is a company established to manage a group of assets bought with money that has been pooled together. For the stock market, a fund represents a company that holds and trades a collection of stocks purchased on its behalf with money collected from shareholders. Investment banks or brokers normally put these funds together. The company holding the funds would then sell shares to anyone who wishes to own a portion of that company or fund.

What are Index Funds?

So, an index fund can be defined as a mechanism created by a company to keep and manage a collection of stocks in a manner that mimics the movement of an index. The company buys the stocks with pooled money from the fund’s shareholders. The Index Fund then reflects the movement of an index (which reflects the movement of a collection of stocks).

Since investors cannot buy an index directly, they would need the help of an Index Fund to achieve rewards that mirror the movement of the larger index. The Sagicor Select Fund represents the first of its kind in Jamaica. It was designed to follow the movement of the financial and insurance equities. Earlier in 2019, on March 1 actually, the Jamaica Stock Exchange established the JSE Financial Index. It is this Index that the Sagicor Select Fund will be tracking.

Advantages and Disadvantages of Index Funds

You can regard Index Funds as another method for investors to gain from the movements in the stock market. That said, there are advantages and disadvantages to consider.

Advantages

  1. An Index Fund consists of diverse stocks. That diversity allows investors to benefit from a spread of the risks across many companies within the Index. Other stocks within the Index cushion the effect of any misfortune befalling individual stocks within the Index. With the purchase of one “stock” – in this case, a share of the  Index Fund, investors benefit from the value of multiple stocks.
  2. Index Funds appreciate in value over the long term bringing significant reward for investors. Even novice investors benefit from a long-term investment in an Index Fund stock.

Disadvantages

  1. It costs extra to own an Index Fund stock. The extra cost comes in the form of a management fee. Fortunately, the management fee is normally low (usually less than one percent of the fund’s annual value).
  2. Diversification limits the gains investors receive from the Index Fund. The gains are lower than that derived from owning each stock individually.
  3. The Index Fund is vulnerable to sector or industry shocks. So, if the industry or sector does badly, the entire index will lose value quickly.

So, there you have it. A brief look at Index Funds and what they mean for the Jamaican investor. While this article does not represent financial advice on whether to buy into the Sagicor Select Fund, it is advisable for you to consult with your financial advisor or broker as you contemplate entering this Sagicor IPO.

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