Index Funds 101



By Joseph Caputo  Chief Information Officer & Associate Portfolio Manager

What is indexing?

Indexing is a way of representing the change in value or the performance of a particular market or market niche over time. Indexes have been developed to represent virtually any market or market segment imaginable. Some of the most prominent stock indexes include the Standard & Poor’s 500 Composite Index (S&P 500), the Dow Jones Industrial Average (DJIA), the Russell 2000, the Nasdaq 100, and the Wilshire 5000. Popular bond indexes include the Dow Jones Composite Corporate Bond Index and the Barclays Capital (formerly Lehman Bros.) Aggregate Bond Index.

Indexing is an investment strategy that attempts to closely track the investment returns of a specified stock or bond market benchmark. Some of the most popular vehicles for indexing are index mutual funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). In each case, the investment is designed to closely track that of a given index.

An exchange-traded fund may be structured as a unit investment trust. However, not all ETFs are UITs, and not all UITs are ETFs.

BWFA gives clients exposure to various markets and specific industries that make up the broader indexes through exchange traded funds (ETFs) that closely mirror many of these indexes, and other indexes. We are able to invest across our model categories to suit our clients’ objectives and goals.

What is an index mutual fund?

An index mutual fund typically holds most or all of the securities represented in a specific index. Index funds typically buy assets and then hold them as long as they are part of the index. An index fund tries to capture the same rate of return as the market the index measures. In contrast, non-index (actively managed) funds try to beat a benchmark (typically an index) by actively selecting securities, regardless of whether they appear in the benchmark index.

Index funds can be structured in many different ways, even those that follow the same market. For instance, some indexes (and therefore the funds that mimic them) may use size to determine which securities and how much of each one to include; they are said to be weighted by market capitalization (market cap). Others may hold an equal amount of each security in the index; these are equal-weighted. As a result, different funds that invest in similar indexes–for example, large-cap stocks–may have different results. Before investing in a mutual fund, carefully consider its investment objective, risks, charges, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.

Strengths

Well diversified

Because index funds generally hold most or all of the securities in their target indexes, they are considered well diversified (assuming the index itself is well diversified). Although the diversification provided by an index fund doesn’t guarantee a profit and can’t protect an investor against market declines, it can help reduce the risk posed by a dramatic drop in any one security or economic sector. (However, bear in mind that some indexes may be dominated by certain industries, such as technology).

Cost efficient

Since index funds are in the form of exchange traded funds, WFA can access investment choices like these that have low expense ratios and low trading costs since they typically trade less frequently than mutual funds, hence the low relative costs for these index funds.

In addition, although many index funds still require hefty up-front minimum investment amounts, some mutual fund companies now offer investors the chance to get into an index fund with a relatively small or no initial lump-sum investment.

Tax efficient

Since index funds normally only buy and sell stocks to adjust for changes to their underlying benchmarks, they experience substantially lower capital gains distributions and tax liabilities. That can be particularly important for a fund that is held in a taxable account.

We here at BWFA offer each and every one of our clients an investment strategy that can take into consideration their specific needs and goals, including financial planning and tax issues. However, we also keep an eye on these benchmarks too!