Index Funds … to Index? Or not to Index?
I’ll tell you flat out, I like index funds. I think they are an appropriate holding for nearly any investor who can tolerate a reasonable amount of risk. So let’s take… a closer look!
What’s an index?
An index is simply a selection of stocks, bonds or other securities that represent a given market. For example, the Standard and Poor’s 500 (S&P 500) is simply the 500 largest companies on the New York Stock Exchange, as measured by the total value of all their outstanding shares. And it’s a very good benchmark for measuring the success of large U.S. corporations. It’s weighted by market capitalization. So the largest company in the S&P 500 (currently Apple, with Exxon-Mobile close behind)
Similarly, the Wilshire 5000 is an index comprised of the 5000 largest companies on the NYSE. The Russell 2000 is a proxy for the fortunes of small cap stocks. There are indexes that measure the bond market, the treasury market, the real estate investment trust (REIT) market and the high-yield bond market. There are indexes for Europe, Asia and South America and just about every individual country in them. There are indexes for gold and precious metals, and for separate industries, like utilities, telecommunications. There’s an index that theoretically, if imperfectly, represents just about any asset class.
So what’s an index fund?
An index fund is simply a mutual fund (or exchange-traded fund) that tracks a given index. Meaning, they hold the same stocks or other securities in the fund that are in the index, and in the same proportion – almost always weighted by market capitalization.
Why index funds?
Well, to understand why people use index funds, it helps to understand a little bit about the theory of markets and investing. Index funds are based on a couple of postulates:
- Markets are efficient. That is, the securities markets factor all known and knowable information about a security into the price of a security very quickly. News is “baked in” to the price of a stock before the news even becomes widely known.
- It is therefore very difficult for individual investors to find bargains at any kind of advantage.
- Money managers, in the aggregate, will tend to underperform their benchmark indexes by roughly the amount of their expenses.
- You can increase your returns, therefore, by decreasing your expenses.
- If you simply have a portfolio that replicates an unmanaged index, you don’t have to pay a professional money manager or a staff of overpaid research analysts to pick what securities to buy and sell.
- Index funds tend to be more stable than actively managed funds – with fewer trades and lower turnover.
- They therefore incur fewer internal trading costs, such as commissions to brokers and bid-ask spreads.
- Because index funds have low trading activity compared to most actively managed funds, they also rack up fewer capital gains distributions. They are therefore more tax efficient than most similar actively-managed funds in the same categories.
- The combination of lower management fees + lower trading expenses + higher tax efficiency is a compelling advantage, over time.
And so, led by a Princeton graduate named John C. “Jack” Bogle, who came up with the concept (though building on some other theoretical work by Harry Markowitz and Eugene Fama), a company called the Vanguard Group rolled out the first index funds.
Now you can buy index funds from just about any major mutual fund company with a fully diversified line-up, and you can buy ETFs via any brokerage company.
Does it work?
Yes. The concept works extremely well. Indeed, in 2011, 84 percent of actively-managed funds underperformed their benchmark indexes, according to a recently released study by Standard & Poor’s. That means that if you picked an actively managed fund to hold for the year, it only stood a 16 percent chance of being a good idea. After all, if your active manager can’t beat the index on a risk adjusted basis, over time, there’s absolutely no sense in paying the manager to do something you can do better on your own, by investing in index funds.
Does indexing always make sense?
No, not for everyone. Index funds are also risky – in that you can lose money in index funds, like with any mutual fund. Some people just cannot tolerate the prospect of losses at all. In these cases, you may be better off in risk free products, such as fixed annuities, GICs (guaranteed investment contracts), money markets, and CDs.
In other cases, an active manager may have a specific strategy that you cannot replicate in an index fund. For example, funds that specialize in arbitrage situations or turnaround situations.
In most cases, though, we do lean towards creating an index fund core to an investment portfolio, and building out from there, depending on the client’s individual situation and risk tolerance.
Tags: diversification, ETFs, index funds, investment advisor, mutual funds, passive investing, portfolio, risk management, taxes
Financial Planning, Investing, Personal finance | thomas | 
9:30 am
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