Index funds, low-cost mutual funds designed specifically to track an underlying index, are extremely useful products for retail and institutional investors. This article will explain the advantages of index funds, and how a smart investor selects among mutual funds.
What is an Index Fund?
An index fund is a type of mutual fund (or exchange-traded fund, ETF) that tracks an underlying financial index. The most commonly-tracked indices are such well-known names as the Dow Jones Industrial Average, the S&P 500 and the Nasdaq. Other index funds track less well-known indices as the Wilshire 5000 or the Russell 2000.
Some index funds track stocks based on their size: small, medium, large or giant. Other index funds track specific industry sectors, such as basic materials, financials or consumer goods. Index funds may track a type stock like value or growth.
Finally, some index funds are geographically specific. The company iShares manages exchange-traded funds that track the stock performance of nations including Germany, Japan and even Singapore.
Investors use index funds to capture the performance of an entire market sector, stock index or nation. But why do index funds even exist? What is their use to investors?
Index Funds and Efficient-Market Hypothesis
Index funds are most useful for those investors who follow efficient-market hypothesis (EMH). This financial theory asserts that stocks and other publicly-traded assets are priced according to all known information. Investors who follow EMH believe it is impossible to consistently outperform the market except through luck.
Academic studies of actively-managed mutual fund performance seem to support EMH. Investment guru William Bernstein devotes several chapters of his outstanding The Four Pillars of Investing to demonstrating the connections between EMH and real-world performance.
What does this mean to investors? Simply this: it is not possible to consistently outperform the market. Therefore, an investor’s total returns will not exceed the returns of the market minus expenses. Therefore, proponents of EMH recommend low-cost, highly-diversified index funds for optimum performance.
Tips for Choosing an Index Fund
Investors examining index funds should pay attention to several core criteria. These include:
*Expenses: As William Bernstein and others remind us, “Performance comes and goes, but expenses are forever.” Since returns are equal to market returns minus expenses, the lower an investor’s expenses, the higher her returns. Vanguard has emerged as the leader in low-cost index funds but several investment firms have begun to offer index funds with equal or even lower costs. The average index fund’s expense rate is in the neighborhood of 0.3%, compared to the average mutual fund expense rate of 1.5%. In addition, index funds should never have a load.
*Index: Index funds track a specific index. Investors should make certain they understand the characteristics of the underlying index being tracked.
*Tracking error: An index fund’s beta should be 1.0. Any deviation from this will affect long-term performance. A certain amount of deviation is unavoidable, but it should be minimal.
*Risk: Index funds share the risk profile of stocks. Although index funds are by their nature somewhat diversified, they are still volatile. In 2008, the S&P 500 (and index funds that tracked that index) lost 40.97%. A loss of this magnitude is sufficient to send many investors running for the hills.
*Tax efficiency: Generally speaking, index funds trade far less than actively-managed funds and therefore are more tax efficient. Because there is less trading, far fewer short-term and capital gains are generated by the average index fund. For these reasons, broad market funds are a good choice for taxable investments.
For all these reasons, index funds are ideal for not just private investors, but even for institutional investors like university endowments and pension funds. By researching and choosing index funds as a component of a diversified portfolio within your risk tolerance, you can minimize expenses and capture the bulk of the market’s returns. Index funds are an ideal investment: boring, reliable, low-expense and readily available. Remember that all equities investments, and even bond investments, are subject to risk of loss.