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Index Fund

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1. What is it?

Index funds, or Exchange Traded Funds – ETFs, aim to invest their resources in a way that will follow the performance of a specific market index. Their quotas as usually traded in the Stock Exchange or over the counter, like stocks. As a practical example, some funds set as benchmark the BOVESPA (Brazilian Stock Exchange) index: they’re traded under the BOVA11 code.

The name of any index fund must identify which index serves as reference for that fund. It is also mandatory to keep 95% of the portfolio of the fund focused on floating assets and other such options authorized by the CVM (the Brazilian SEC): provided these options integrate the reference index or reflect its variation and profitability. This type of fund allows for trading in derivatives and swap – long term contracts with exchangeable profits.

The great advantage of investing in index funds is the chance of having access to all stocks that compose an index, without having to purchase them directly and separately. Acquiring each stock individually would amount not only to great purchase costs, but to enormous brokerage fees as well. So the choice of an index fund provides great diversification in terms of stock portfolio. Besides, having its quotas traded on the stock exchange provides the investor with a guarantee for other stock exchange trades of their choice, or even the possibility to “rent out” quotas, should they wish to hold them for a longer term.

Risks of investing in this type of fund are the same incurred upon for any variable income investment: market risks. Liquidity is also a risk factor, considering this “quota trading” has still a low liquidity in the stock exchange. The greatest advantage, however, is the diversification of non-systemic risk, ie, the risk of investing in a single company. So the great advantage of ETFs is diversification, it is as if you owned shares of various companies.

The investor choosing index funds will incur in the same costs as a stock investor. Meaning:

  • Brokerage fee: charged when a quota is bought or sold. May be either a percentage or a fixed amount.
  • Custody fee: a monthly fee will be charged by the brokerage house for taking custody of the stock and for other such services.
  • Administrative fee: will pay the administrator for services rendered. A key factor to observe when choosing a fund, since high charges may impact profitability.

To be traded on the Exchange, the shares have a system of calculation, giving an indicative price of shares of the funds traded in the market. This system of calculation is called IOPV (indicative optimized portfolio value). It is calculated by multiplying the amount of portfolio assets by their latest prices traded on the Stock Exchange and is calculated every 30 seconds.


2. Taxation

Taxation in index funds is similar to taxation in stocks. The rate charged on transactions in index funds is 15% on the capital gain.

At the time of the funds constitution, if an investor sells off their stock they’ll be exempt of taxes in negotiations up to R$ 20 thousand. At the time of redemption, if the investor chooses to be paid in stock, the same rules apply up to R$ 20 thousand. Taxes will only be charged in the event of redemptions payable in cash, and there is no exemption from taxation..


3. Advantages

  • Diversification – One of the biggest advantages of index funds, because it somewhat represents the purchase of a combination of stocks, avoiding the concentration in only a few options
  • Risk management – Index funds follow the performance of various stocks while not minimizing systemic risk and balancing risk versus return;
  • Savings on brokerage fees – if the investor had to buy enough stock to replicate a specific index brokerage fees would be overwhelming
  • Administrative fees tend to be smaller than in other types of funds
  • All quotas are traded in the Stock Exchange, making it possible for the investor to even use these quotas as guarantee in other trades.

4. Disadvantages

  • Investment funds are not guaranteed by the Credit Guarantee Fund
  • High administrative fees may affect profitability.
  • High risk because they invest in variable income bonds and are, therefore, subject to possible loss.

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