Investing Unit 6: Index Funds

January 11, 2010 Print Friendly and PDF





Index funds are mutual funds that track a stock or bond index. Index funds buy all of the securities in an index, or a representative sample of it, thus providing about the same performance as the index they are tracking, minus fund expenses. In other words, index funds earn approximately the market rate of return. If stock prices rise, index fund performance (i.e., the value of index fund shares) will rise accordingly. The opposite is true, however, if stock prices plummet. In this case, the share prices of index funds will fall. Index funds have been in existence since 1976 when the fund known today as the Vanguard 500 Index Fund was launched.

An index is an unmanaged collection of securities whose overall performance is used as an indication of stock or bond market trends. Examples of indexes include the widely-reported Dow Jones Industrial Average or DJIA, which tracks 30 large companies; the Standard & Poor’s (S&P) 500, which tracks 500 large U.S. companies; the Russell 2000, which tracks small companies; the Wilshire 5000, which tracks almost every listed U.S. stock; and the Lehman Aggregate Bond Index, which mirrors the performance of U.S. bonds.

There are also indexes that track the performance of foreign securities. Among the most widely quoted is the Morgan Stanley Capital International EAFE (MSCI EAFE) index. EAFE is an acronym that stands for “Europe, Australasia, and Far East” and the EAFE index is used to track the performance of international stocks much like the S&P 500 is used as a benchmark for American stocks.

In both bull (rising) and bear (declining) markets, index fund returns beat those of many actively managed (non-index) mutual funds. One reason is that index funds have relatively low turnover, which helps keep taxable capital gains distributions and trading costs low. Turnover is the frequency with which stocks and bonds are traded in a mutual fund portfolio.

Due to their low turnover, some index funds have expense ratios (expenses as a percentage of a mutual fund’s assets) of 0.2 (one fifth of one percent), compared to an average expense ratio of 1.5% for actively managed funds. Over time, this difference in fund expenses can really add up and provides index funds with a significant and ongoing performance advantage.

Recommendations

Below are some recommendations about index funds provided by investment experts:

  • Purchase index funds directly from investment companies instead of through brokers. First, you already know what you are purchasing: the same securities that comprise a market index. Thus, your need for advice is limited. In addition, mutual funds that are sold by brokers often have front or back-end loads (fees) and/or a 12b-1 fee for marketing expenses, which increases the fund’s expense ratio.
  • Consider investing in index funds especially for “efficient” segments of the stock market where detailed information about stocks is readily available. An example is U.S. large company stocks. When there are many stock analysts following the performance of certain market segments, it is difficult for an actively managed mutual fund to find an “undiscovered” gem of a stock that will grow enough in value to offset the inherent cost advantage of index funds. On the other hand, an actively managed fund that invests in so-called less-efficient market segments, such as small company stocks, might have a better chance of beating the returns of an index fund.
  • Appreciate the fact that fund expenses really matter! According to an article in the AAII (American Association of Individual Investors) Journal, a 1% difference in returns due to expenses, for an index fund earning 8% after expenses versus an actively managed fund earning 7% after expenses, results in an advantage of over $79,000 for the index fund on a $100,000 initial investment over 20 years.
  • Diversify your portfolio. Successful investors should own a variety of asset classes (e.g., stocks and bonds) and diversify their investments within each (e.g., large and small company stocks) because no one has a “crystal ball” with respect to market performance. This is very easy to do with index funds. For example, an investor could purchase a total stock market index fund, a total bond market index fund, and a total international index fund for exposure to securities in overseas markets.

Many people select actively managed funds because it is human nature to want to believe that there are “wizards” who can quickly grow your money. It is often impossible, however, to determine whether a fund manager’s superior performance was due to skill or luck. With index funds, you know what you’re investing in and you can regularly track the benchmark index on which your fund is based.

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This work is supported by the USDA National Institute of Food and Agriculture, New Technologies for Ag Extension project.