Index Fund Investing: Fundamentals Every Investor Should Know
For those of you who currently invest in mutual funds, I will briefly explain what you should understand about them. I do this to briefly compare them with Index funds. The Basis of Mutual funds are as follows:
- Managed professionally – Known as active management
- Have a stated objective – e.g. large cap or small cap or bonds, foreign as examples.
- Diversified – They have anywhere from 50 to 300 stocks or bonds in them and not known for sure what you own.
- They are relatively easy to understand
- Liquidity based on daily trade at 4 PM during market hours and settlement within 3 to 4 days.
- Higher portfolio turnover (frequently buying and selling positions)
- Needs research analysis team
- Higher costs than Index Funds
That is the basics. There is more to this, including management costs, trading costs, who really own the underlying investments and objective deviation to name a few of the issues.
Index fund investing
An Index fund is based on the position of stocks or bonds that mirror the performance of a particular index.
For example, an S & P 500 Index Fund will mirror the performance of the stocks inside this index of 500 largest US companies. Barclays Capital U.S 5-10 year corporate bond index will have only corporate bonds that meet that description. So let’s look at the main points.
- Mirrors a particular index
- Passively Managed
- Lower management costs
- Replication of Indexes eliminates the cost of research analysis teams
- Lower Expense Ratios
- Low portfolio turnover (not always buying and selling positions)
- The index is the benchmark
Actively managed index funds will have difficulty in outperforming their benchmarks. The reason is the additional management costs associated with this approach. However, this is not to assume that index funds are the only way to go when investing. Index fund investing are simply another tool for you to grow your wealth.
An index fund is a set it and forget it
When discussing diversity, one could create an asset allocation based on risk tolerance from both actively managed funds and index funds. The percentage mix will not be discussed as that is based on risk tolerance.
So, for example, if one needed the following asset allocation
- S. Large Blend
- S. Large Value
- S Large Growth
- S Mid Blend
- S Mid Value
- S. Mid Growth
- S. Small Blend
- S Small Value
- S. Small Growth
- Foreign Large Blend
- Diversified Emerging Markets
- Intermediate-Term Bond
It could be accomplished by just investing in these asset classes through actively managed mutual funds or it could be accomplished by investing in these same asset classes using index funds.
The end results after 10 years could be extremely different. Research after research has demonstrated that index fund investing tend to outperform their actively managed mutual funds well over 60% of the time on average.
The more actively managed funds you add to an asset class, compared with an all index funds within an asset class typically created, even more, underperformance. Or, to say it another way, the index fund performance was higher more of the time the longer the time was with fewer funds.
This is not to say that index funds are the end-all in creating a portfolio. Most brokers do not wish to present index funds as there is little to no commission on these positions.
I would recommend that you do your own homework. Even when using an advisor or broker, expect expert advice from them, not commission advice.
One way to do this is to create your own index fund portfolio using a no-load brokerage account. Another way to get expert advice from a broker is to use wrap accounts using only index funds.
They will help you create the fund and actively manage it for a fee, not a commission. The underlying index funds with the lower costs will help offset the wrap account fee.