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Getting Started in Index Funds

Getting Started in Index Funds

The growth in the number and size of index funds has been explosive in recent years, thanks to the interest shown by pension funds, insurance companies, and other big institutional investors. All of this "smart" money going into index funds — funds which are designed to simply “match,” not exceed, the general performance of the market — illustrates just how difficult it can be to outperform the market. If investing in the right stocks at the right time was a simple matter, everyone would be wealthy!

For those not familiar with index funds, here's a brief discussion of their strengths and weaknesses.

First, let's make sure you understand what we're talking about. An index fund is a special kind of mutual fund that has only one objective: to mirror the performance of a “market index,” such as the Standard & Poor's 500 stock index. Different indexes (and there are lots of them) measure different parts of the market. Some measure the performance of small-company stocks, others track the performance of large-company stocks, still others are designed to measure the entire market.

In an index fund, the portfolio manager invests only in the securities that are used in calculating the target index. The fund will make or lose money to the same extent the index on which it is patterned shows gains or losses.

For example, if the S&P 500 gains 15% in a given year, then any S&P 500 index fund should also gain about 15% that year. From an investing point of view, what could be simpler?

Here are some of the advantages index funds offer:

They guard against sub-par investment returns. Index funds help assure that your results are in line with those of the general market.

Lower expenses. Index funds tend to have low operating expenses and transaction costs. The overhead of Vanguard's index funds runs about 0.25% per year, about one-sixth of what a typical stock fund might incur.

Fewer taxable distributions. Index funds require only minimal trading in the portfolio. This reduces the amount of capital gains taxes, a significant advantage if you're investing outside a tax-deferred retirement account.

Easy accessibility. Index funds are increasingly being offered in 401(k)s and retirement plans. Most such plans commonly offer at least one index fund focused on a large-company stock index (like the S&P 500) and one focused on a small-company stock index (like the Russell 2000 or S&P 600). Many go beyond this, offering index funds that track foreign funds, medium-sized companies, and other market segments. The inclusion of these funds makes it easier to include your retirement assets in your overall allocation strategy.

Index funds also have disadvantages, some of which were exposed during the bear market of 2008 - 2009. Indexing's disadvantages include:

No protection during periods of market weakness. Index funds  are designed to be fully invested in a portfolio of stocks which reflects the indexes they are designed to mimic, and they stay fully invested at all times. Because they're on automatic pilot, so to speak, they're called "passively-managed" funds. The managers of "actively-managed" stock funds, on the other hand, can take defensive measures during market downturns, such as increasing their holdings of cash or high dividend-paying stocks. Such efforts may or may not help cushion the fall, but at least the managers are free to try.

A narrow target. By this we mean index funds invest only in those securities that are part of the index they are imitating. An S&P 500 fund, for instance, invests only in the large companies that comprise that index. This means such a fund owns no small companies or foreign stocks. When large company stocks do well, so will an S&P 500 index fund. When stocks of small companies are in favor, an S&P 500 index fund will be a relatively poor performer compared to a Russell 2000 or Wilshire 4500 index fund.

Too help counteract the “narrow target” problem, Sound Mind Investing’s Just-the-Basics strategy uses several funds, including those that invest in small companies, foreign stocks, and bonds.

Indexing isn't an all or nothing proposition. Many investors, including sophisticated institutions, invest 50%-75% of their money in index funds, using them as "core" positions to anchor their portfolios. With the rest of their investments, they can venture into "beat the market" type strategies.

These investors know that even if some of their more adventurous holdings go awry, they can rely on the indexes to keep them close to average (i.e. matching the market). In investing, being average isn’t always such a bad thing.

Austin C. Pryor, Jr., founder of Sound Mind Investing and author of the Sound Mind Investing Handbook, is an American financial writer, speaker, and radio personality whose work focuses on investment counseling from an evangelical Christian point of view.

Publication Date: June 20, 2012