Index Funds

An index mutual fund matches the performance of a market or group of stocks and mirrors a specific stock market index. Index funds exist for a variety of markets, such as short-, intermediate-, and long-term bonds; US large-company and small-company stocks; value and growth stocks; international stocks; emerging market stocks; and so on. Some examples include the 30-year Treasury bond index and the 13-week T-bill index.

One of the popular indexes followed by index mutual funds is the Standard & Poor's 500 index. When you invest in an index fund, you are investing in a basket of stocks, giving you the impression you are diversifying your portfolio. However, the S&P 500 index tracks the performance of 500 of the largest and most profitable companies in the US, so you are not really diversifying your portfolio among all stocks; you're only investing in large-growth US stocks.

Index mutual funds follow other indexes as well, including the Nasdaq Index (technology stocks), the Russell 2000 Index (2,000 smaller-company stocks), the Wilshire 5000 Index (the entire stock market, around 9,000 stocks), and the Dow Jones Industrial Average (30 large-company stocks). Take a look at the performance of an index fund over the last 30-50 years. You will see that its performance will be similar to the performance of its benchmark index. When the index goes up, your fund will perform well, but if the markets are in a bearish mode, your fund will not.

Index funds are passively managed, meaning the fund manager doesn't decide what stocks to buy and sell, but matches the makeup of the index followed. The holdings of an index mutual fund only change when the index it follows changes its holdings. For example, as of December 7, 1999, Yahoo! was added to the S&P 500, replacing Laidlaw, Inc. This change sent all the managers of funds associated with the S&P 500 scrambling to sell shares of Laidlaw and purchase Yahoo! shares for their portfolios.

This differs from an actively managed mutual fund, where the fund manager buys and sells securities depending on their objectives and strategies. However, the performance of most actively managed funds is measured against a relevant index. It is a difficult task to outperform this benchmark, and the majority of funds are unable to do so. Therefore, index mutual funds become appealing investments. Indexfunds.com comments that "over the long term, the S&P 500 index has beaten about 65% to 80% of mutual funds, depending on the time period." In addition, Fool.com noted that approximately 80% of mutual funds underperform the stock market's returns in a typical year.

ADVANTAGES

There are certain advantages to index funds compared with other forms of financial instruments:

1. Low fees -- Most sources indicate that mutual fund owners will pay lower expenses compared with actively managed funds. Considering index funds are passively managed, you would think that management fees would be substantially lower, but you'd be surprised. Believe it or not, some index funds do charge higher fees. Some go so far as to charge sales loads.

2. Low turnover -- Most index funds have a low share turnover because their holdings include equities that make up a specific index. Since the makeup of the market indexes doesn't change often, index funds do not change their holdings as often as actively managed ones. This low turnover helps minimize capital-gains taxes. Just as with the low fees, don't accept this blindly. Some index funds follow indexes that shift assets frequently; these funds will have a high turnover. Further, during a bull market, some index funds may have a good chunk of unrealized capital, but the pain will be felt during a bear market, when an increasing number of investors may request redemptions. This will force fund managers to liquidate shares, creating capital gains that investors will have to declare at income tax time.

3. Convenience -- Index funds are easy to buy and sell. Some funds allow you to set up an automatic investment plan for as little as $500, or you can set up an automatic investment plan where you can add a regular amount per month to your account. T. Rowe Price Equity 500 Index (PREIX) and the Transamerica Premier Index Fund (TPIIX), both of which track the S&P 500, give investors the option to add $50 a month.

DISADVANTAGES

There are some disadvantages to index funds as well:

1. Low cash reserves -- This is a mixed blessing. Many actively managed funds keep a significant percentage (say, 8%) of the money invested in cash reserve, in case cash is needed to cover a struggling position or to time an anticipated market move. Index mutual funds will hold a significantly lower percentage or, in some cases, no money in reserve. Even though this means a larger percentage of your investment is invested in the market, it also means a lack of protection in the event of a downturn.

2. Risk -- By investing in a specific index, you are limiting your investment to the type of stocks that make up the specific index, whether they are large-growth stocks, international stocks, or small-company stocks. There is always the possibility that the index your fund follows will take a downturn. If that happens, your investment will go down with the index. Index funds are less risky than most actively managed funds. It may be a disadvantage compared with a money market fund, but not compared with an actively managed equity fund.

PERFORMANCE

Given the mutual fund options available, index funds should not be overlooked. Even within the index fund category, you have more than 160 choices. Before selecting an index fund, consider the expenses -- how closely the fund matches its index, the turnover rate, and load-adjusted returns.

FIGURE 1: AVERAGE LOAD-ADJUSTED RETURNS AS OF 10/27/00. Here are three funds that follow the S&P 500; this comparison will give you an idea of how expenses affect returns. The Vanguard 500 Index (VFINX) incurs annual expenses of 0.18%. The T. Rowe Price Equity Index [PREIX] incurs annual expenses of 0.4% plus a 0.5% redemption fee. The MainStay Equity Index A [MCSEX] has an annual expense ratio of 0.94%, a front load of 3.0%, and 12b-1 fees of 0.25%. Not surprisingly, the Vanguard 500 Index comes out on top.

To get an idea of how expenses affect returns, take a look at Figure 1. It compares three funds that follow the S&P 500 index. The Vanguard 500 Index (VFINX) incurs annual expenses of 0.18%. The T. Rowe Price Equity Index [PREIX] incurs annual expenses of 0.4% plus a 0.5% redemption fee. The MainStay Equity Index A [MCSEX] has an annual expense ratio of 0.94%, a front load of 3.0%, and 12b-1 fees of 0.25%. Not surprisingly, the Vanguard 500 Index comes out on top.

Figure 2 shows the daily price chart comparison for the Vanguard 500 Index Fund and the S&P 500 for the last three years. As you can see, the two lines are nearly identical. The slight discrepancy can be attributed to low fund expenses.

FIGURE 2: VANGUARD 500 VS. S&P 500. Here's the Vanguard 500 Index [VFINX] compared with the S&P 500 over the last three years. With passive management, the Vanguard 500 is able to mirror the results of the S&P 500.

CONCLUSION

Are index funds better or worse than actively managed funds? On one hand, they are passively managed and thus have lower fees and less turnover in the equities it holds. On the other hand, they carry risks and need to be scrutinized just as with any other investment. In the end, before investing in index funds, find out how much they cost, what their share turnover is, and how their performance compares against the index they follow.