Index Funds — Are they right for you?by Gabriel. is an. approach that seeks to match. returns of a stock or bond index. An. tries to. the

Index Funds — Are they right for you?

by Gabriel Nijmeh

Indexing is an investment approach that seeks to match the

investment returns of a stock or bond index. An investment

manager tries to duplicate the target index by holding all the

securities in the index. This is what is called a passive

management approach which emphasizes broad diversification and

low portfolio turnover.

There are a variety of indexes to suit each investment style. The

largest and well known index is the S&P 500. This index is

dominated by the largest blue chip companies and accounts for

close to 75% of the U.S. stock market value. Other indexes

include the Nasdaq, Wilshire 5000 Total Market Index, S&P MidCap

400, Morgan Stanley Capital International Europe, Australasia,

Far East (MSCUI EAFE) and various bond indexes.

Since 1926, the stock market has an average rate of return of

11.3%. Investors have earned more or less depending on the type

of investments and risks taken. It is very important to note that

this return is before costs have been factored. Therefore, those

investing in actively managed mutual funds may have a net return

lower due to these costs and thus will earn significantly less

than the market average.

These costs include:

- Management expense ratio (including advisory fees, distribution

charges and operating expenses)

- Transaction costs (brokerage and other trading costs)

Index fund expense ratios are typically 1 percent and usually

even less, compared with 1.5 to 3 percent for actively managed

funds. Fund expenses and transaction costs for a typical mutual

fund can take a big bite out of your net investment returns. Add

sales commissions to your purchases and even more of your returns

are swallowed. Typically, index funds can be purchased on a no-

load basis thus saving you sales charges.

Of course, there is always a caveat. during periods of market

decline, index funds can be expected to suffer somewhat larger

declines over actively managed funds. A fund manager can make

adjustments in anticipation of market declines by selling stocks

and also has the option of holding a cash reserve. This is not

something that occurs within an index fund because you are fully

invested in the market and potentially corrective actions are not

taken. Accordingly they may be regarded as a riskier option for

some investors during market declines.

It can also be argued that when you invest in an actively managed

mutual fund, you are paying a professional to research and pick

winning stocks. You are not paying them 2 or 3 percent a year to

park your holdings in cash. If that were the case, you would be

better off putting your money in your savings account. It really

depends on market conditions and the fund’s investment philosophy

and how it matches with your investment goals.

Another common thought is why shoot for an average return when

you can try and beat the market. Well, it is very difficult even

for seasoned money managers to consistently beat the index year

over year.

Taxes are another aspect of investing that needs to be considered

carefully. Every time an active fund manager sells a profitable

stock, a taxable capital gain is triggered. Anytime some of an

investment is taxed away, the magic of compounding is

compromised. Index funds on the other hand are considered tax

efficient investments because very few stocks are bought and sold

and therefore few capital gains are distributed to investors. You

choose when to sell your investments and therefore have a bit

more control over the tax consequences. Index investing was once

only available to institutional investors who take tax deferral

seriously.

Indexing is a strategy that can be applied in many different

ways. It is an efficient and low cost way to investment across

various markets and asset classes. You can build a core holding

of index funds and add a well managed mutual fund that enhances

your portfolio’s return.

What appeals to me about indexing is that I can have a broad