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Index 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 reconstituted.
     
  • Tax efficient – Index tracking requires less trading, resulting in fewer unanticipated yearend 1099 pass-through dividends and capital gain distributions.
     
  • Consistent 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.

Drawbacks to Passively Managed Index Funds:

  • Accepting 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.
     
  • Insufficiently 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 investors.
     
  • Masked 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.

 

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