Index Tracking Risk: Big Gains Mean Big Exposure

Index tracking has become a very popular method of investment for mutual funds. With this investment strategy, a mutual fund attempts to replicate the movement of a financial index. However, when this type of index fund posts big gains, this can also mean big risk for you as an investor. Here are a few things to consider about big gains in index funds.

Financial Indices

Investing in an index fund can be one of the safer forms of investment in the market. A financial index essentially tracks the stock market by keeping track of a certain amount of critical stocks in the market. For example, the S&P 500 measures the performance of the top 500 companies in the country. Therefore, this represents the vast majority of business in the stock market. When the S&P 500 goes up, the stock market also went up.

Historically, the market does well in the long run. Therefore, as an investor, you should realize that down periods in the market are only temporary. With this in mind, being able to replicate the performance of the market would provide you with steady growth in your portfolio. The index fund attempts to do this by purchasing a diversified portfolio of stocks from a particular index. For example, if the index fund was based on the S&P 500, the fund would purchase all stocks from companies that make up the S&P 500. When that index moved up or down, the value of the fund would move in sync.

Big Gains

While index funds represent a solid investment strategy, many investors get tired of simply trying to track the index and want a bigger return on their investment. Instead of trying to stay with the index, they try to beat it. There are many funds out there called enhanced index funds that appeal to this type of investor. This type of fund uses principles of an index fund, it attempts to beat the gains that are posted by the index using alternative investment strategies. Therefore, it is not a true index fund and can move in a more volatile fashion than the index itself.

Big Exposure

With this type of fund, you are essentially taking on a greater level of risk for your money. When you track the index exactly, your risk level is significantly lowered. However, when you try to beat the index, you will inevitably have to expose yourself to the market more. Traditionally this means trying to choose which companies in the index will perform better than others. Therefore, someone is essentially picking stocks for the fund. Anytime that you try to pick stocks and beat the market, there is an added level of risk. 

Investment Considerations

As an investor, you have to decide whether the advertised extra rate of return for the fund is worth the extra risk that is involved. If you truly want a diversified fund that tracks the market, a traditional index fund would be best. However, if you want a fund that can beat the performance of the market and you do not mind the additional risk, an enhanced index fund could be for you.

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