[Index Fund Basics] Are They a Mistake or the Way to Go

index fund basicsAnytime you are learning about investing you can’t avoid the words: indexes and index fund investing.

It can be hard to tell if this is a trend, hype or really a great way to invest.

Following I will cover what indexes are, what index funds are, the advantages and disadvantages of an index fund followed by advice on how to use index funds in your own portfolio.

What is a Market Index?

Indexes are “baskets” of stocks, bonds or other investments that are meant to give you a broad idea on how the market or sector that it is tracking is performing.

The first index was the Dow Jones Industrial Average started in 1896.  Since its creation many more indexes have been developed to help investors get a better understanding of how different parts of the market are performing.  Indexes are created by companies for various purposes, including research, and for tracking their own performance.  Index examples are the Standard & Poor 500 (S&P 500), Russell 2000 or the Barclays US Aggregate Bond.

Indexes are calculated a few different ways, the main two being based on price and market capitalization.  The most basic and original calculation involved adding all the prices of the stocks in the index and then dividing by the number of stocks in the index.  While this is still the basis for price based calculations, most of them now do some tweaking of the formula to try and smooth out the impact of stock splits and other factors that give too much weight to non market factors.

You will also find indexes that are market cap weighted, so they can adjust for the size of the company.  These indexes track the stocks by proportion of how large they are.  These calculations can end up having larger companies make a bigger impact on the index.  In between these two basic formulas are many variations to attempt to eliminate market variables that might skew the index, such as size and stock splits.

For your investing purposes, it is not important that you know exactly how an index is calculated, but more important that you understand what the index is actually tracking.  The video below shows you two ways to find out what investments are in an index.

What is an Index Fund?

An index fund is a type of mutual fund that tries to match the returns of the index it is following.  This can be done three different ways.

The first is traditional indexing, which simply mirrors the index by owning the same stocks that the index follows, some may allow for a small allocation to futures to help maintain cash flow and liquidity.

The second is synthetic indexing which attempts to mimic the index by using futures, bonds and other instruments.  The belief is that they can eliminate tracking risk, but in the process they add other types of risk.

The final type is a fund using enhanced indexing.   These funds use customized indexes, timing strategies, execution techniques and other tools to try and offset tracking error.  Many of these should technically fall under actively managed and not indexing.  They tend to have higher fees and more variation from the index’s return than a traditional index fund.

Advantages of Index Funds:

Low Fees

The fees on index funds are typically lower since the investment decisions are based on allocations to match the chosen index and not on a team of researchers selecting investments.  Since fees can have a big impact on your return, index funds low fees allow you the extra wiggle room to earn less on your investments and still come out ahead.

For more information on the impact of fees on your investments: Mutual Funds and Fees

Low Turnover & Tax Efficient

Because the fund is mimicking an index, which typically does not change frequently, there is less buying and selling within the fund, so your turnover ratio is lower.  This reduces your expenses due to trading and creates an investment that is tax efficient because it does not create as many capital gains as an actively managed fund.

No Style Drift

When you have an actively managed fund you can get what is termed as style drift.  Style drift is when the fund moves from one category to another as the manager changes investments.  So you may have a small cap fund that drifts from growth to value or even up to mid cap.  When you invest in an index you will not see drift as the fund sticks to the index.  So if you invest in and S&P 500 index funds then you know you are getting large cap stocks and that will not change.  This makes it easier to keep to your target allocation exactly where you want it.

No Management “Error”

One of the biggest risks in using an actively managed fund is that the managers may make bad investment decisions.  Bad decisions can mean not getting the same return as the market.  Using index mutual funds allows you to get the same return as the market.  While you might think that a good actively managed fund will consistently beat the market and thus make you more money but the data proves otherwise.  Depending on the year, 50 – 80% of the actively managed funds do not beat the market.  In fact this is one of the reasons that index investing got started.

Less Investment Knowledge Needed to get Started

One thing that I love about index investing is that it is an easy way to get started investing while you are trying to learn all the terminology.  Because they are straight forward in what they do and because you don’t have to worry about other issues such as quality of management you can get started right away.  Later in this post we will go over what you do need to look at to get started.

Disadvantages of Index Funds:

Tracking Error

No fund can get the exact return of the index.  This occurs for many reasons, but the biggest one is fees.  Since they charge a fee to manage the fund you are automatically making less than the index.  Another reason variation can occur is when the index changes the investments that they track, the fund must add or subtract that investment.  This change tends to impact the price of the stock in the market place.  So the fund that has to buy it to match the index may end up paying more for the stock, or end up getting less when they have to sell.

No Outperforming the Market

Since a fund is not actively managed and you pay fees the fund most likely will not beat the market.  While this may seem like a bad decision to invest in one since you will not have the opportunity to make more, remember that your actively managed funds have a hard time beating the market.  Especially since their fees are much higher, so if they charge 2%, they have to beat the market by 2% just for you to do what the market is doing.

How Does Index Fund Investing Fit in my Portfolio?

So how do you decide if Index investing is right for you?  Ask yourself the following questions:

  • Do I want to monitor the performance of active managers?  You may find you just prefer index investing so you know you are following the market and don’t have to keep tabs on what your manager is doing.  This really is the most “laid back” form of investing.
  • Your active management choices are bad.  Maybe your investment options in your 401K are full of fees or bad performers; this is a great case for using index funds.  Especially since index funds are frequently one of the options available in your 401K. (No 401K – check out this post on things you can do to make up for it.)
  • When doing your search for a good fund, no active funds are consistently beating the market.  This third approach is the one that I usually follow.  If nothing else is meeting my criteria then I go with an index fund.

How to Find the Best Index Fund?

So you have decided that index funds are the right investing strategy for you.  So now how do you determine which ones are right for you.  The first step would be to make sure you know your target allocation you are trying to achieve.

Once you know what type of stock/bond combination you are looking for you can begin to look for funds that match your needs.  If you have decided to go straight index investing then you can go to either Morningstar.com and use their index fund screener or select a fund company that you like and evaluate their index funds.

Your biggest concern with an index fund is expense ratio, try and stay as low as possible.  You should not be paying over .5% and even that is high!  Don’t pay a load and remember that the more you pay in fees the more you are under performing the market. Following are two video walking you through how you can search for funds based on your desire to invest in only index funds and how to tell if an index fund is enhanced or traditional.

Other Thoughts

In addition to index mutual funds, many ETF’s are set up to also track indexes.  These typically have even lower fees than mutual funds.  They are a great option for money that you are going to leave in the fund for an extended period of time because the fees are lower than a funds.  Keep in mind that there are transaction costs each time you purchase shares, so you don’t want to be consistently purchasing in low dollar amounts.  Additionally they do not do automatic reinvesting of dividends, so you will incur additional reinvestment fees to get the dividends back into the market.  I use ETF’s for broad market index funds that I will keep for years (probably at least 10), and then use the dividends from the ETF to help me reallocate when I do my yearly investment check up.

You can also use indexes to ensure that all your funds are doing what they are supposed to be doing.  Comparing your return to the return of an index will help you know if you may need to get out of a fund.

Index fund investing is a great way to get the returns of the market without the extra cost and active management issues.  Check them out as a great way to get started investing.

Resources:  If you want to know more about active management struggling to consistently beat the market check out this book: A Random Walk Down Wall Street (Affiliate Link).

Roger @ The Chicago Financial Planner says October 30, 2012

Great post. I use index funds and ETFs to a large extent in the portfolios that I design for my clients. The biggest benefit is the style purity and the fact that in many asset classes index funds tend to outperform the majority of the active fund managers. Index products are great for asset allocation which in my mind is the key to managing risk.

    Andrea says October 30, 2012

    @ Roger Thank you, I am glad you liked the post! They are a great way to drive a portfolio that you know will preform and keep you allocation exactly the way you want it!

Suzanne @ Financial Advisor Coach says November 2, 2012

Andrea, just found your blog (thanks to Roger). Really enjoyed your article (I’m ex VG). Suzanne

    Andrea says November 5, 2012

    @ Suzanne – Welcome to the site and thank you very much!

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