Closed-End Funds (CEFs)
Exchange Traded Funds
Index funds are mutual
funds that are designed to replicate the performance of a specific index.
Index investing is
ideally suited to most investors. It is of particular value to those
individuals wanting to participate in the capital markets, with all of its
associated risks and rewards, but who have no interest in devoting the time
and effort involved with self investing.
The performance of index
funds never precisely mirrors the benchmark index; there are operating
expenses and matching inconsistencies that occur.
There are basically two
types of index funds. There are funds that track the performance of broad
indexes, such as the DJIA, S&P 500, Russell 2000 and the Wilshire 5000;
there are also funds that track more specialized indexes, and benchmark
their performance to certain market segments or investing styles. Before
purchasing either type, investors should read the prospectus of the fund
that is of interest. Differences do exist: Some funds only invest in a
representative sample of an index; others use derivatives to meet their
objectives, while others keep a certain percentage of the fund’s assets in
cash to cover redemptions.
A critical feature of
index funds is that they are passively managed. This opens up a discussion
of the differences between actively managed funds and passively managed
funds. Keep in mind that both types are legitimate investment tools that can
strategically assist in building wealth. Actively managed mutual funds are
run by managers who deliberately select securities, in accordance with the
particular fund’s charter, to actively try to beat the performance of the
market. Passively managed funds, however, just try to match the performance
of the index that they are attempting to benchmark. Therefore, the index
creators, those who decide on the original and future composition of the
index, play an important role. Indexing segments and styles requires a
certain degree of judgment and discretion.
Benefits of Passively
Managed Index Funds:
- Low cost –
This is the major advantage! The fund
manager only replicates his benchmark index, resulting in less research,
monitoring and trading cost. Index funds have no upfront sales charges,
and their annual expense ratios are normally 1% to 2% lower then
comparable actively managed funds. The lower the expenses, the higher the
returns for the investors. Actively managed funds, however, require more
work, making them more expensive to operate. Everything else held
constant, a 1% to 2% lower annual investment expense make an enormous
difference in the value of one’s portfolio over a lifetime.
- Low risk –
Each share consists of a diversified
pool of stocks, with interest across a broad market or a specific sector.
Proper diversification, however, depends on what index is used and the
individual investor’s overall asset mix and financial situation. For
example, if all one owns is the S&P 500 index, while the index is
diversified, it still lacks exposure to small companies, international
companies and fixed income securities. Nonetheless, owning an index fund
has lower risk than owning a specific stock.
- Low turnover –
Investing in indexes requires
less trading, and is suited for the buy and hold investment strategy.
There is some turnover, however, as the indexes are constantly being
- Tax efficient –
Index tracking requires less trading, resulting in fewer
unanticipated yearend 1099 pass-through dividends and
capital gain distributions.
investing objectives – Index
funds don’t change their objectives. Actively managed funds, however,
sometimes shift their style (type of holdings), especially in cases where
a fund dramatically grows in size.
Passively Managed Index Funds:
mediocrity – The goal of index
funds is to mimic averages. Usually, average translates into a low return.
- High concentration
of mega stocks or overvalued stocks -
There are a few different ways that indexes can be weighted. An
average of the stock prices of the securities within the index can be
used, similar in form to the calculation of the DJIA. Most of the indexes,
however, weight their stock allocation according to the market
capitalization of the stocks that are being benchmarked. Each stock is
represented in proportion to its market value. Indexes weighted by market
capitalization, emphasize the mega stocks and overvalued stocks over the
smaller or undervalued stocks. Even with the S&P 500, major companies such
as Exxon, GE, Microsoft, Coca Cola and a few others control the
performance of the index. Here’s what occurred in
Canada: starting in September 2000, some
investors in the Canadian TSE 300 index were surprised as the value of
their investment dissipated. That September, Nortel accounted for over 30%
of the TSE 300 index. Subsequently, as Nortel collapsed, the index went
with it. Many of the other Canadian equities and mutual funds, however,
were up in value, while the TSE 300 had a major decline. Weighting is a big issue. There are also various other alternative weighting
methods being used.
researched investments –
Investing in an index means stocks are purchased (and sold) solely on
their presence and weighting within the index. Trading decisions are not
made on the fundamentals of an investment.
- Inflating values
of smaller stocks – Stocks in an
index with a small float (the amount of tradable shares), can be
artificially pushed up in price, as index buying tries to replicate the
stocks that are benchmarked.
- Fund rebalancing
lowers returns – When stocks are
added to an index, they normally increase in value beforehand; after
inclusion in the fund, they return to their more normalized prices.
Reconstitutions initially have a negative effect on the returns for index
accountability – Passive or not,
money is being paid to manage these investments, yet no one is accountable
for poor investment returns.
There can be a place for
index funds in most portfolios, but, as with all investments, it depends on
the individual investor’s goals, objectives and financial situation.