Posted on: 13 April, 2002
Author: Gabriel Nijmeh
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 NijmehIndexing is an investment approach that seeks to match theinvestment returns of a stock or bond index. An investmentmanager tries to duplicate the target index by holding all thesecurities in the index. This is what is called a passivemanagement approach which emphasizes broad diversification andlow portfolio turnover.There are a variety of indexes to suit each investment style. Thelargest and well known index is the S&P 500. This index isdominated by the largest blue chip companies and accounts forclose to 75% of the U.S. stock market value. Other indexesinclude the Nasdaq, Wilshire 5000 Total Market Index, S&P MidCap400, 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 of11.3%. Investors have earned more or less depending on the typeof investments and risks taken. It is very important to note thatthis return is before costs have been factored. Therefore, thoseinvesting in actively managed mutual funds may have a net returnlower due to these costs and thus will earn significantly lessthan the market average.These costs include:- Management expense ratio (including advisory fees, distributioncharges and operating expenses)- Transaction costs (brokerage and other trading costs)Index fund expense ratios are typically 1 percent and usuallyeven less, compared with 1.5 to 3 percent for actively managedfunds. Fund expenses and transaction costs for a typical mutualfund can take a big bite out of your net investment returns. Addsales commissions to your purchases and even more of your returnsare 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 marketdecline, index funds can be expected to suffer somewhat largerdeclines over actively managed funds. A fund manager can makeadjustments in anticipation of market declines by selling stocksand also has the option of holding a cash reserve. This is notsomething that occurs within an index fund because you are fullyinvested in the market and potentially corrective actions are nottaken. Accordingly they may be regarded as a riskier option forsome investors during market declines.It can also be argued that when you invest in an actively managedmutual fund, you are paying a professional to research and pickwinning stocks. You are not paying them 2 or 3 percent a year topark your holdings in cash. If that were the case, you would bebetter off putting your money in your savings account. It reallydepends on market conditions and the fund's investment philosophyand how it matches with your investment goals.Another common thought is why shoot for an average return whenyou can try and beat the market. Well, it is very difficult evenfor seasoned money managers to consistently beat the index yearover year.Taxes are another aspect of investing that needs to be consideredcarefully. Every time an active fund manager sells a profitablestock, a taxable capital gain is triggered. Anytime some of aninvestment is taxed away, the magic of compounding iscompromised. Index funds on the other hand are considered taxefficient investments because very few stocks are bought and soldand therefore few capital gains are distributed to investors. Youchoose when to sell your investments and therefore have a bitmore control over the tax consequences. Index investing was onceonly available to institutional investors who take tax deferralseriously.Indexing is a strategy that can be applied in many differentways. It is an efficient and low cost way to investment acrossvarious markets and asset classes. You can build a core holdingof index funds and add a well managed mutual fund that enhancesyour portfolio's return.What appeals to me about indexing is that I can have a broadbasket of stocks that moves lockstep with the market so at thevery least I am guaranteed a market return. In addition, I canpurchase individual stocks or other mutual funds that will addvalue and enhance my overall rate of return.Do index funds fit in your portfolio? This is something you needto determine based on your investment goals and philosophy. Overthe long term index funds should provide competitive returnsrelative to actively managed mutual funds while keeping yourcosts down. Article Tags: Index Funds, Actively Managed, Managed Mutual, Mutual Funds Source: Free Articles from ArticlesFactory.com