IFYF Monthly Investing Messages

Personal Finance July 01, 2014|Print

 

 


 

Investing For Your Future Monthly Message

July 2014

Barbara O’Neill, Extension Specialist in Financial Resource Management

Rutgers Cooperative Extension

oneill@aesop.rutgers.edu

Index Funds101

Index funds are mutual funds that contain all, or a statistically representative sample, of stocks or bonds in a benchmark market index.  Some examples of indexes are the Standard and Poor’s 500 (S&P 500), which tracks the performance of U.S. large company stocks, and the even broader Wilshire 5000, which includes S&P 500 stocks, plus a large number of smaller U.S. firms. The Wilshire 5000 index tracks the market value of almost all actively traded U.S. stocks combined.

Index funds have been in existence since 1976 when the fund known today as the Vanguard 500 Index Fund was launched. They buy all of the securities in an index, or a representative sample, thus providing about the same performance as the index they are tracking, minus fund expenses. In other words, index funds earn approximately the market rate of return. If stock prices rise, index fund performance (i.e., the value of index fund shares) will rise accordingly. The opposite is true, however, if stock prices plummet.

An index is an unmanaged collection of securities whose overall performance is used as an indication of stock or bond market trends. Examples of popular market indexes include the widely-reported Dow Jones Industrial Average, which tracks 30 large companies; the Standard & Poor’s (S&P) 500 (described above); the Russell 2000, which tracks small companies; the Wilshire 5000 (described above); and the Lehman Aggregate Bond Index, which mirrors the performance of U.S. bonds.

There are also indexes that track the performance of foreign securities. Among the most widely quoted is the Morgan Stanley Capital International EAFE (MSCI EAFE) index which serves as a benchmark for the performance of securities from Europe, Australia, and Southeast Asia. The EAFE (acronym for Europe, Australasia, Far East) index has been in existence for over 30 years and is used to track the performance of international stocks much like the S&P 500 is used as a benchmark for American stocks.

Why consider investing in an index fund?  One reason is performance.  According to the book, The Index Fund Solution, by Richard Evans, about two-thirds of actively managed funds are outperformed by indexes in a typical year. On average, a typical actively managed mutual fund underperforms its comparable index by about two percent per year. Two percent does not sound very much but, over time, costs matter.  Evans gives the following example in his book.  If someone invests $10,000 for 50 years at 10%, he or she would have $1,174,000. If the rate of return is 8%, the accumulation drops to $469,000 or over $700,000 less.

Index funds maintain their significant cost advantage because they are very efficiently run.  Some have expense ratios less than two-tenths of one percent, compared to 1.5% for average actively managed stock funds.  Index funds also have low turnover (how often a fund buys and sells securities), which reduces transaction costs and capital gains taxes.  The average index fund has a turnover of rate less than 5%, compared to 85% for average stock funds. In both bull (rising) and bear (declining) markets, index mutual fund returns beat those of many actively managed (non-index) mutual funds.

Index funds are particularly advantageous in years when market returns are less than spectacular.  The lower a fund’s return, the higher the impact of fund expenses.  Evans gives the following example to illustrate this point.  If an investor earns 15% and pays 1% expenses, there is a 7% reduction in return.  If an investor earns only 5%, however, the 1% expenses represent a 20% reduction in return or three times more.       

There are currently almost 400 index funds managing assets of $1.1 trillion, according to a 2012 report by the Investment Company Institute (see http://www.ici.org/pdf/2012_factbook.pdf).  Of households that own mutual funds, a third owned at least one index mutual fund. Equity (stock) index funds accounted for the bulk of index fund investments. The Vanguard Group has a broad selection of index funds, but requires a $3,000 initial investment ($1,000 for retirement accounts).  Many other investment firms (e.g., Schwab and Fidelity) also offer index funds, some with lower required minimums (e.g., $1,000).

Despite increased attention paid to index funds in recent years, their total assets still represent just a small fraction of all money invested in mutual funds.  Some of the reasons for this include investors’ desire to beat the market and their belief that there are gifted fund managers that can do this.  While some funds do manage to beat the market each year, there is, unfortunately, no way to predict them in advance.  It is human nature to want to believe that there are “wizards” who can quickly grow your money. It is often impossible, however, to determine whether a fund manager’s superior performance was due to skill or luck.

With index funds, you know what you’re investing in and you can regularly track the benchmark index on which your fund is based. To save money, purchase index funds directly from investment companies instead of through brokerage firms. First, you already know what you are purchasing: the same securities that comprise a market index. Thus, your need for advice is limited. In addition, mutual funds that are sold by brokers often have front or back-end loads (fees) and/or a 12b-1 fee for marketing expenses, which increases the fund’s expense ratio. Index funds may also be available through a 401(k) or 403(b) retirement savings plan.

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