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Could You have done Better?
Is it something you could have done with your eyes closed? Could you have beaten the overall market and done it without losing sleep. Could you have done it without losing unnecessary fees for management, the tax consequences of mutual funds constantly repositioning themselves, and without the worry that you will miss the next best thing? Index funds think so, and they have the numbers to back themselves up.
Long relegated to the category of boring, these passive, usually inexpensive investments have found their niche among investors. Investors whose concerns for their accumulated wealth, or simply, their conservative attitude toward the whole idea of preparing for the future, has lead them to look for indexed funds to keep their money involved in the market, but spread among many stocks or bonds. Indexed funds do offer some type of protection, although be warned, if the overall market is headed down, your fund will follow. But the theory is, because of diversification, you have minimized your losses.
In many indexed funds, the goal is more than simply mimicking the markets or providing diversification, but to also be tax efficient. Selling stocks within a mutual fund usually incurs some sort of tax consequence. That tax liability, should it be on capital gains from a stock sold at a profit, is passed on to you. It is the hidden expense that many fund owners ignore. Until, that is, they find that much of their earnings are wiped out by these tax liabilities. These are especially painful when the market has declined, and their are tax bills to be paid. It is the proverbial double whammy.
If you indexed last year, you were part of a wave of investors who found solace in this type of investing. In fact, according to Strategic Insights a mutual fund tracking service, three out of every five dollars invested found its way into some type of index fund. Losing their appetite for risk, investors are now looking at the broader market.
But indexing isn't a no-brainer. When is spending money on your future ever easy? Index funds can charge a wide range of expenses for tracking an index such as the Standard & Poors 500. Vanguard charges some of smallest amounts for their funds while some fund families actually charge load fees. This is the most outrageous gouging and they wouldn't do it, I suppose, if investors stopped and thought about what they were doing.
I mentioned tax efficiency. To explain what this means let's pretend that you are a fund manager. You might have to cover redemptions by shareholders, rebalance your fund because of new money, or worse, park money in bonds to cover folks who want to withdraw their money. All of these have tax effects that take place when you have to sell shares of your holdings to cover.
When funds do sell stocks for reason or another, you will pay. How much you have to pay is determined by the holding itself. If a fund tracks small caps for instance, selling a holding could be the result of an increase in size. This means that selling at a profit will incur taxes. If you see stocks exiting from the S&P 500, it usually because they have grown too small. Selling these stocks usually has minimal effects because the overall percentage of the holding is lesser. A stock that falls into this "too small" category, would also be among the last 231 stocks in the index and would hold less than o.10% of the total funds assets. Sales this small do not usually increase the tax burden by much.
So if even this investment vehicle has its pitfalls, how do pick one that will do good for you? For one, know what your fund is indexing. Funds that track the total market invest in all 6,600 equities which gives you a broad range of companies. Some index funds, specialize or expand their specific index to cover additional stocks within a specified category. Domini Social Equity is one such fund that comes to mind. It tracks the S&P 500 but adds another 150 or so companies to their list. Speaking of lists, below you will find the most common index types:
Wilshire Large Growth
S&P 500
Wilshire Large Value
Wilshire Mid-Cap Growth
S&P 400
Wilshire Mid-Cap Value
Wilshire Small Growth
Russell 2000
International Index
International Indexes
MSCI The World
MSCI EAFE
MSCI Emerging Markets
Bond Index
Bond Indexes
Lehman Bros. Long-Term Govt/Corp
Lehman Bros. Interm-Term Govt/Corp
A final word about indexes, They do not necessarily buy every stock in the index. Some companies are too small,and because of that, funds can not purchase shares. If they did, these companies would have inflated share prices because there just isn't a lot of stock to buy. This is called illiquid. The cost of the transaction plus the sudden interest in the company would increase the price of the stock and the weighting (the percentage to the index) would change.
Index funds mimic the index they follow. A fund that mimics the Wilshire 5000 probably does not own all 5000 companies, but rather, a select portion of them. Once again, some companies are just too small.
In the coming months, the New York Stock Exchange will begin a series of indexes design for its equities. It will do this in coordination with Dow Jones, the worlds leading indexer. Dow Jones Indexes include the Dow Jones Averages, the Dow Jones Global Titans 50, the Pan-European Dow Jones STOXX Indexes, the Dow Jones Asian Titans 50, the Dow Jones Sector Titans 30, the Dow Jones Global Indexes, the Dow Jones U.K. Titans 50, the Dow Jones Canada Titans 40, the Dow Jones Japan Titans 100, the Dow Jones Style Indexes, the Dow Jones Total Market Index Series, the Dow Jones REIT Indexes, the Dow Jones-AIG Commodity Index, the Dow Jones Islamic Market Indexes, the Dow Jones Internet Indexes and the Dow Jones Sustainability Indexes. Dow Jones Indexes is part of Dow Jones & Company, which publishes the world's most vital business and financial news and information.
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