Index Funds - Are they right for you?

Index Funds - Are they right for you?
by Gabriel Nijmeh

Indexing is an investment approach that seeks to match the
investment returns of a stock or bond index. An investment
manager tries to duplicate the target index by holding all the
securities in the index. This is what is called a passive
management approach which emphasizes broad diversification and
low portfolio turnover.

There are a variety of indexes to suit each investment style. The
largest and well known index is the S&P 500. This index is
dominated by the largest blue chip companies and accounts for
close to 75% of the U.S. stock market value. Other indexes
include the Nasdaq, Wilshire 5000 Total Market Index, S&P MidCap
400, 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 of
11.3%. Investors have earned more or less depending on the type
of investments and risks taken. It is very important to note that
this return is before costs have been factored. Therefore, those
investing in actively managed mutual funds may have a net return
lower due to these costs and thus will earn significantly less
than the market average.

These costs include:

- Management expense ratio (including advisory fees, distribution
charges and operating expenses)

- Transaction costs (brokerage and other trading costs)

Index fund expense ratios are typically 1 percent and usually
even less, compared with 1.5 to 3 percent for actively managed
funds. Fund expenses and transaction costs for a typical mutual
fund can take a big bite out of your net investment returns. Add
sales commissions to your purchases and even more of your returns
are 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 market
decline, index funds can be expected to suffer somewhat larger
declines over actively managed funds. A fund manager can make
adjustments in anticipation of market declines by selling stocks
and also has the option of holding a cash reserve. This is not
something that occurs within an index fund because you are fully
invested in the market and potentially corrective actions are not
taken. Accordingly they may be regarded as a riskier option for
some investors during market declines.

It can also be argued that when you invest in an actively managed
mutual fund, you are paying a professional to research and pick
winning stocks. You are not paying them 2 or 3 percent a year to
park your holdings in cash. If that were the case, you would be
better off putting your money in your savings account. It really
depends on market conditions and the fund's investment philosophy
and how it matches with your investment goals.

Another common thought is why shoot for an average return when
you can try and beat the market. Well, it is very difficult even
for seasoned money managers to consistently beat the index year
over year.

Taxes are another aspect of investing that needs to be considered
carefully. Every time an active fund manager sells a profitable
stock, a taxable capital gain is triggered. Anytime some of an
investment is taxed away, the magic of compounding is
compromised. Index funds on the other hand are considered tax
efficient investments because very few stocks are bought and sold
and therefore few capital gains are distributed to investors. You
choose when to sell your investments and therefore have a bit
more control over the tax consequences. Index investing was once
only available to institutional investors who take tax deferral
seriously.

Indexing is a strategy that can be applied in many different
ways. It is an efficient and low cost way to investment across
various markets and asset classes. You can build a core holding
of index funds and add a well managed mutual fund that enhances
your portfolio's return.

What appeals to me about indexing is that I can have a broad
basket of stocks that moves lockstep with the market so at the
very least I am guaranteed a market return. In addition, I can
purchase individual stocks or other mutual funds that will add
value and enhance my overall rate of return.

Do index funds fit in your portfolio? This is something you need
to determine based on your investment goals and philosophy. Over
the long term index funds should provide competitive returns
relative to actively managed mutual funds while keeping your
costs down.