When talking about investing you may frequently hear about indexes and index fund investing.  Yet you may be wondering if this is just another investment fad or if it could have a place in your investment portfolio.  Following we are going to give you a look at what indexes are, what index funds are, the advantages and disadvantages of an index fund followed by advice on how to use index funds in your own portfolio.

What is a Market Index?

Indexes are “baskets” of stocks, bonds or other investments that are meant to give you a broad idea on how the market or sector that it is tracking is performing.  The first index was the Dow Jones Industrial Average started in 1896.  Since its creation many more indexes have been developed to help investors get a better understanding of how different parts of the market are performing.  Indexes are created by companies for various purposes, including research, and for tracking their own performance.  Index examples are the Standard & Poor 500 (S&P 500), Russell 2000 or the Barclays US Aggregate Bond.

Indexes are calculated a few different ways, the main two being based on price and market capitalization.  The most basic and original calculation involved adding all the prices of the stocks in the index and then dividing by the number of stocks in the index.  While this is still the basis for price based calculations, most of them now do some tweaking of the formula to try and smooth out the impact of stock splits and other factors that give too much weight to non market factors.

You will also find indexes that are market cap weighted, so they can adjust for the size of the company.  These indexes track the stocks by proportion of how large they are.  These calculations can end up having larger companies make a bigger impact on the index.  In between these two basic formulas are many variations to attempt to eliminate market variables that might skew the index, such as size and stock splits.

For your investing purposes, it is not important that you know exactly how an index is calculated, but more important that you understand what the index is actually tracking.  The video below shows you two ways to find out what investments are in an index.

What is an Index Fund?

An index fund is a type of mutual fund that tries to match the returns of the index it is following.  This can be done three different ways.

The first is traditional indexing, which simply mirrors the index by owning the same stocks that the index follows, some may allow for a small allocation to futures to help maintain cash flow and liquidity.

The second is synthetic indexing which attempts to mimic the index by using futures, bonds and other instruments.  The belief is that they can eliminate tracking risk, but in the process they add other types of risk.

The final type is a fund using enhanced indexing.   These funds use customized indexes, timing strategies, execution techniques and other tools to try and offset tracking error.  Many of these should technically fall under actively managed and not indexing.  They tend to have higher fees and more variation from the index’s return than a traditional index fund.

Advantages of Index Funds:

Low Fees

The fees on index funds are typically lower since the investment decisions are based on allocations to match the chosen index and not on a team of researchers selecting investments.  Since fees can have a big impact on your return, index funds low fees allow you the extra wiggle room to earn less on your investments and still come out ahead.

For more information on the impact of fees on your investments: Mutual Funds and Fees

Low Turnover & Tax Efficient

Because the fund is mimicking an index, which typically does not change frequently, there is less buying and selling within the fund, so your turnover ratio is lower.  This reduces your expenses due to trading and creates an investment that is tax efficient because it does not create as many capital gains as an actively managed fund.

No Style Drift

When you have an actively managed fund you can get what is termed as style drift.  Style drift is when the fund moves from one category to another as the manager changes investments.  So you may have a small cap fund that drifts from growth to value or even up to mid cap.  When you invest in an index you will not see drift as the fund sticks to the index.  So if you invest in and S&P 500 index funds then you know you are getting large cap stocks and that will not change.  This makes it easier to keep to your target allocation exactly where you want it.

No Management “Error”

One of the biggest risks in using an actively managed fund is that the managers may make bad investment decisions.  Bad decisions can mean not getting the same return as the market.  Using index mutual funds allows you to get the same return as the market.  While you might think that a good actively managed fund will consistently beat the market and thus make you more money but the data proves otherwise.  Depending on the year, 50 – 80% of the actively managed funds do not beat the market.  In fact this is one of the reasons that index investing got started.

Less Investment Knowledge Needed to get Started

One thing that I love about index investing is that it is an easy way to get started investing while you are trying to learn all the terminology.  Because they are straight forward in what they do and because you don’t have to worry about other issues such as quality of management you can get started right away.  Later in this post we will go over what you do need to look at to get started.

Disadvantages of Index Funds:

Tracking Error

No fund can get the exact return of the index.  This occurs for many reasons, but the biggest one is fees.  Since they charge a fee to manage the fund you are automatically making less than the index.  Another reason variation can occur is when the index changes the investments that they track, the fund must add or subtract that investment.  This change tends to impact the price of the stock in the market place.  So the fund that has to buy it to match the index may end up paying more for the stock, or end up getting less when they have to sell.

No Outperforming the Market

Since a fund is not actively managed and you pay fees the fund most likely will not beat the market.  While this may seem like a bad decision to invest in one since you will not have the opportunity to make more, remember that your actively managed funds have a hard time beating the market.  Especially since their fees are much higher, so if they charge 2%, they have to beat the market by 2% just for you to do what the market is doing.

How Does Index Fund Investing Fit in my Portfolio?

• Do I want to monitor the performance of active managers?  You may find you just prefer index investing so you know you are following the market and don’t have to keep tabs on what your manager is doing.  This really is the most “laid back” form of investing.
• Your active management choices are bad.  Maybe your investment options in your 401K are full of fees or bad performers; this is a great case for using index funds.  Especially since index funds are frequently one of the options available in your 401K. (No 401K – check out this post on things you can do to make up for it.)
• When doing your search for a good fund, no active funds are consistently beating the market.  This third approach is the one that I usually follow.  If nothing else is meeting my criteria then I go with an index fund.  (Following is a video on how I decide which approach I will go with.)