The Case for Indexing

In 1975 John Bogle, the founder of mutual fund giant Vanguard founder, pioneered the first index fund.

Contrary to the then-current thinking on Wall Street, his idea was radical and sent a wave of tremors through the hearts of mutual fund aficionados everywhere. Instead of trying to beat the broad market - as most fund managers set out to do - Bogle created an extremely low cost mutual fund whose design was to equal, or mirror the returns of the S&P 500 index, by purchasing stocks in amounts equal to the weightings within the index itself. And with that unique idea, he single-handedly, transformed the mutual fund industry.

The catalyst that prompted Bogle's invention was the poor performance of actively-managed funds, which were habitually underperforming the market. Bogle predicted the returns of the broad market would continue to beat actively-managed funds by 1.5%. However, even he underestimated that number, as the gap widened in the 1990's, with the S&P 500 returning 17.3%, while the average mutual fund gained just 13.9%. Today, it's the status quo. Some 85% of actively-managed funds under-perform the S&P 500 regularly.

Many investors have no idea of this shortfall, or the reasons for the discrepancy between actively-managed and index funds. But they boil down to this. Actively-managed funds have:

• High expenses, with expense ratios averaging 1.5%
• Rapid turnover (the constant buying and selling of shares) averaging 85%
• Habitually held large cash reserves which don't return anything to shareholders

However, millions of other investors caught on quickly and decided that returns equaling or coming close to market gains sounded pretty good when compared with the alternative of buying under-performing funds. The ability to easily diversify was also attractive. And the icing on the cake was that the expenses of most broad market index funds are low and reasonable. The rest is history, and the growth of index funds has been tremendous in recent decades.

While there is an index fund for just about any sector of the market you might desire to invest in, our focus today is on the broad market indexes.

The most widely-followed index is the S&P 500, which consists of the shares of 500 large companies, weighted according to their market capitalizations. To easily understand this, consider hypothetically, that you have two companies to put in an index: Company A and Company B. The latter company has a market cap of $200 billion, twice the $100 billion market cap of the first company, so your proportional ownership of Company B will be twice your ownership of Company A, in terms of dollars invested.

The goal of the index fund is to buy the same stocks in similar proportions to the index it is tracking, thereby mirroring the return. Of course, expenses will be deducted, and some funds have a little leeway to change the composition of the fund, so that it may not exactly produce the same returns as the underlying index.

To reach their investment goals, some index funds invest in derivatives; some invest in every company that is included in the underlying index; others only invest in a representative selection of the companies in the index. Consequently, the index fund returns may be less or even better than those of the index. But the returns for both should be close.

The Vanguard 500 (VFINX) , which mirrors the S&P 500 is the best known broad market index fund. Other broad market index funds include:

Broad market indices provide great diversification as well as tax efficiency, but you are investing in primarily, large-cap companies. But not to worry; index funds are available for small- and mid-cap companies, too, as well as foreign companies. Some funds to consider include:

• Fidelity Spartan Extended Market (FSEMX) , which tracks the Wilshire 4500 Index
• Vanguard Extended Market (VEXMX ) , which tracks the S&P Completion Index
• Vanguard Mid Cap Index (VIMSX) , which tracks the MSCI US Mid-Cap 450 Index
• Vanguard Small Cap Index (NAESX) , which tracks the MSCI US Mid-Cap 1750 Index

And for foreign index funds, try:

• Vanguard Developed Markets (VDMIX) or Fidelity Spartan International  (FSIIX) , which track the MSCI EAFE Index
• Vanguard Emerging Markets (VEIEX) , which tracks the Select Emerging Markets Free Index

In the past few years, an alternative investment has emerged that also mirrors the returns of stock market indices. Exchange-traded funds (ETFs) are a rapidly growing segment of this part of the investing arena. In next week's issue, we will discuss ETFs and their advantages and disadvantages, compared to index funds that track similar market indices.

About the Author
Nancy Zambell, Contributing Editor to BrokerAdviser.com's Financially Fit, has enjoyed a diversified career in the financial services industry. Read More

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