SECTION 5 INDEX FUNDS

Chapter 12: Index Funds

An index fund is a bundle of stocks. The stocks that the fund holds are the same stocks, with the same weightings (percentages) as the stocks represented in a particular index, such as the S&P 500 index. You cannot own an index. You can own the same stocks as the index—an index fund.

The only time a stock in an index fund is bought or sold is when the publisher of the index makes a change in its lineup. For instance, if the S&P 500 expels ABC Company and replaces it with XYZ Company, then any index fund tracking the S&P 500 will do the same thing. This is mutual fund investing in its simplest form.
Index funds are said to be “passively-managed” because there is really not much to manage, which is why the costs are so low. As it turns out, more intense managing does not equate to more money for mutual fund shareholders, only more money for Wall Street.
Index funds do not buy or sell stocks often because changes to the underlying index do not often occur. This keeps capital gains tax liability low. The index fund avoids the expense associated with a lot of buying and selling—such as high-priced analysts, costly research, and the expense of conducting numerous transactions. The savings enable these funds to compete very effectively with mutual funds that are trying to beat the market.

Again, other mutual funds, known as “actively-managed funds” incur transaction costs and taxes as they compete against the market each day. They try to outsmart the market—to little or no avail. Actively-managed funds have highly-paid managers and a great deal of additional overhead to cover. Annual expenses for index funds are often one-tenth as much as the annual expenses of actively-managed mutual funds, or less.

Exchange-Traded Funds

Index funds are also available as exchange-traded funds (ETFs). ETFs are index mutual funds that trade like individual stocks. An investor may pay a commission to purchase or sell the ETF, a commission that’s fully disclosed on your trade confirmation, as if the ETF were an individual stock. Annual operating expenses for many ETFs are even lower than the annual expenses
of many of their index fund cousins.

Certain index funds and ETFs are more efficient than others. For my
clients, I stick with broad-based index funds, such as those representing the S&P 500 (for exposure to large companies) or the Russell 2000 (for exposure to small companies). I avoid narrowly-focused funds—funds that invest in a single market sector, such as healthcare or finance. Some ETFs are levered—
that is, the fund’s manager borrows money or purchases derivatives to increase the bet on a strategy. I do not recommend investing in levered funds because they are much riskier and more expensive to own.

ETFs are more transparent than actively-managed mutual funds. Mutual funds report holdings monthly or quarterly. Most issuers of ETFs, such as Barclays, report the current holdings of their various ETFs on a daily basis.

The primary differences between mutual funds and ETFs are as follows:

• ETFs are bought and sold throughout the day, like individual stocks. Mutual fund transactions are processed once per day.

• ETFs can be much less expensive to own than actively-managed mutual funds.

• ETFs are much more tax-efficient than mutual funds because they have much lower turnover (buying and selling) of the investments in the fund.

• The lower operating expenses and lower turnover of passive ETFs provide a significant advantage over mutual funds, unless commissions for ETF transactions are too high. Discount brokers will do trades for a few dollars.

• Investors pay a commission to buy or sell an ETF, and there will be a spread between the “bid” and “ask” price for an ETF. In other words, an ETF is traded just like a stock.

• Many different ETFs have been issued since the investment product was created in 1993. Most ETFs subscribe to passive management, though the industry has developed some actively-managed ETFs. Some ETFs have a very broad focus—such as the S&P 500 or the Wilshire 5000—while others are very narrowly focused on a single commodity, such as gold, copper or oil. The more narrow the focus, the greater the volatility in the investment.

• Some ETFs are leveraged.

• Just as a mutual fund can under perform a particular benchmark index, ETFs can as well. Even though a passive ETF seeks only to match or rep- licate the returns of a given index, it can fall short of that objective. The difference in the index’s return and the ETF’s return is called “tracking error.”

In my practice, I have found that owning index funds and ETFs provide my clients with cost-effective, broad exposure to many asset classes.

I have also found that direct investments in bonds can help my clients achieve financial security at a very low cost. In the next chapter, I will discuss the use of bonds in a portfolio.

Have a question? Contact Ed Mahaffy.

Receive Complimentary Copy Of eBook (Includes All Graphic Charts)