Close-up: Index Fund

n.

Index Fund: A mutual fund that buys securities to match that of a broad-based index such as the S&P 500. The fund aims to achieve the same return as the general market.

If you think back to high school English class, one of the key lessons when it came to writing was to use an active voice, not a passive voice. In other words, don't write, "Italy is a country I'd like to visit."Instead, write, "I want to visit Italy."The meaning behind the two sentences is virtually identical, but the manner in which they are written makes all the difference to an English teacher. Active is good, passive is bad.

Mutual Funds for Dummies

However, when it comes to mutual fund investing, passively managed index funds are actually a very good thing. They're not managed by a portfolio manager and a team of analysts, explains Eric Tyson in (Hungry Minds Publishing; 2001). In fact, they're often managed by a computer. They don't try to beat the market; rather, they try to replicate it. "An S&P 500 index fund buys and holds exactly the same 500 stocks that comprise the S&P 500, in exactly the same amounts that comprise the S&P 500," Tyson writes. So why are they so good?

Making the Case

One of the most attractive aspects of index funds is their low cost. Since computers do most of the work, there's no need to hire a fund manager or research analyst. And keeping expenses low can make all the difference in the world when it comes to your returns. As Tyson points out, "The average US stock fund has an operating expense ratio of 1.4% per year."In contrast, index funds can have expense ratios as low as 0.2% per year. And if you think that 1.2% difference between the average stock fund expense ratio and average index fund expense ratio does not seem like a lot, consider what happens when factored over the long haul.

About.com's mutual fund Web site (www.mutualfunds.about.com) offers the following example, comparing an index fund and a managed fund over a 20-year period. If you leave $50,000 in an index fund that charges 0.2% for expenses, in 20 years you will have paid $9146 in fees and forgone earnings. Over that same period, a managed fund that charges 1.2% annually will cost you $49,991. And if the managed fund charges 2.2%, the cost over 20 years is $83,692—considerably more than the $50,000 you left in the account.

Examine the Numbers

Unfortunately, most investors don't examine fund fees closely enough. According to the About.com article, most investors don't even look at fund fees. Instead, they're fixated on performance, unaware that fund fees can easily eat away a significant portion of a fund's performance. And when it comes to performance, index funds fare quite well over the long haul.

According to Paul Merriman, editor of the mutual fund newsletter FundAdvice.com, of the 355 stock funds that existed in 1970, only 169 are still in existence. More importantly, only nine of them have outperformed the S&P 500 since then. He points out that in his opinion, the expense ratio is one of the most important variables in a diversified portfolio. The other is tax efficiency, and index mutual funds excel there as well.

Tyson writes that managers of actively managed mutual funds buy and sell individual securities more frequently in an effort to increase shareholder returns. As a result, the chances that a fund will need to make significant capital gains distributions increases. Index funds make fewer taxable distributions to shareholders because fewer trades are made. Therefore, if you're investing money outside of a retirement account, index funds prove to be tax-friendlier.

On a final note, Tyson points out that because managers of actively managed funds make more frequent trades, the chances of making a costly mistake also increase. It's possible the fund manager could be too heavily invested when the market declines, or not invested at all in a particular sector should the market go up. And an index fund, by its very definition, will never underperform the market index.

Inside the Numbers

Mutual Funds for Dummies

There are two virtual guarantees when you invest in index funds. The first, according to Eric Tyson, author of (Hungry Minds Publishing; 2001), is that you'll never see your funds on the list of the top-performing funds. However, you also won't see it on the list of the worst-performing funds.

For a comparison, consider Tyson's list of the worst-performing US index funds over a 10-year period from 1991 to 2001 vs two stock market index funds:

In short, Tyson notes, don't overestimate a fund manager's ability to consistently pick the right stocks. Index funds certainly make sense for a portion of a diversified portfolio.

POP QUIZ

1) Index funds are managed by

• computers
• ouija boards

2) Expense ratios are lower on index funds than standard mutual funds. True or False?

• False

3) How many stock funds have outperformed the S&P 500 since 1970?

• 9
• 15

4) One drawback to index funds is that they are not tax efficient. True or False?

• False

5) How often are index funds on the list of worstperforming funds?

• occasionally
• never