To understand index funds, you must first understand what a stock market index is.
A stock market index is a list of stocks whose combined performance is tracked by investors as an indication of the health of a particular portion of the economy. Even people who know little or nothing about the stock market have heard of some of the more famous indexes and the companies they track—for example, the Dow Jones Industrial Average, the oldest and best-known index, tracks the stocks of 30 of America’s bigger, more famous firms, including American Express, Coca-Cola, Walt Disney, McDonald’s, and Wal-Mart Stores.
The value of the Dow is calculated by combining the share prices of all 30 companies according to a special formula. As the values of these companies rise and fall, the Dow rises and falls with them.
Because the Dow reflects the performance of the stock of only 30 companies, it can’t accurately reflect the diversity of the entire U.S. economy — much less the world economy. So over the years, other indexes have been invented by various financial companies, each mirroring the performance of a different group of stocks:
- The Standard and Poor’s (S&P) 500 Index: Tracks the performance of some 500 large U.S. companies. S&P 500 is often referred to as a “broader” index than the Dow because it’s more inclusive and therefore reflects more general trends in American industry.
- The Wilshire 5000 Index: Tracks virtually the entire U.S. stock market.
- The Russell 2000 Index: Tracks smaller, fast-growing companies.
- The Morgan Stanley Select Emerging Markets Index: Tracks companies in developing regions of the world, such as South America, Southeast Asia, and Eastern Europe.
An index fund is a mutual fund that buys the stocks contained in a particular index. For example, the Vanguard Index Trust — the first index fund, founded in 1976 — owns shares of all the companies in the S&P 500. The investment objective of an index fund depends on the index being followed. A broad index reflects changes in the overall economy, which usually moves more gradually than any single business sector. Thus, a broad index is usually less volatile than a more narrow one; and so, in general, the broader the index, the more conservative the fund. Index funds are available today based on every popular stock market index.
As you may imagine, managing an index fund is less challenging than managing most other fund types. The manager of an index fund is simply charged with buying and selling stocks to match those contained in its index. This style of fund management is sometimes called passive investing. By contrast, other funds are run by managers who must constantly make independent investment decisions; this is known as active investing.
Because passive investing calls for less complicated managerial decisions, the cost of running an index fund is less than with other fund types. Thus, investors in index funds generally incur lower management fees.
In general, index funds perform well; in fact, the majority of funds that are actively managed actually grow less quickly than such broad indexes as the S&P 500! “Beating the indexes” isn’t an easy challenge, even for a highly skilled professional money manager. So index fund investing has become a particularly popular choice among investors who want to enjoy some of the strong growth possible in the stock market while minimizing the risks that go with active management. Because passively managed funds trade less often than actively managed funds, index funds generate less capital gain income than most other funds.
Stock mutual funds (sometimes also called equity mutual funds) invest primarily in stocks (also called equities). Although you can find many specific types of stock funds with widely varying risk and reward characteristics, stock funds in general outperform bond funds. Stock funds are top performers because they’re invested in the stock market, which has proven, over many decades, to be the world’s fastest-growing investment arena.
Over the past 20 years, the return of stock funds has been quite good — about 14.8% in average annual gain, including all kinds of profits (growth in net asset value, dividends, and capital gains).
However, a tradeoff is involved. The higher growth of stock funds comes with somewhat greater risk. Stock funds may rise or fall, depending on the behavior of the overall stock market, of particular industries, or of the specific companies selected by the fund manager. In a prolonged bear (declining) market, stock funds may even stagnate for a period of months or years.
The longer your investment horizon (that is, the more you are focused on long-term rather than short-term investment goals), the more appropriate stock funds are for your portfolio. If you expect to cash in your investment within the next three years, you should consider keeping all or most of your money in bond funds or other relatively safer investments. Not all stock funds behave alike. Wide variations are possible among stock funds in terms of risk, volatility, and growth potential. The following sections highlight some common types of stock funds, with explanations of how each kind of fund can be expected to perform.
Another disadvantage of mutual funds relates specifically to bond funds — that is, funds that specialize in bonds rather than stocks or other investments. Typically, when you invest in an individual bond, you are given a maturity date — that is, the date when the loan represented by the bond comes due. On that date, you get back the amount you paid for the bond (the principal), plus interest. The return is certain, unless the company or the government body that issued the bond runs into financial difficulties. An investment in a bond fund works differently. The fund manager is continually buying and selling bonds with a variety of maturity dates. Periodically, you receive a portion of the interest earned by the fund. However, no specific maturity date exists for your shares in the fund, and thus no certainty about the amount you can expect to receive when you decide to sell your shares. You may end up selling your shares in the fund for more or for less than you paid.
When you own an individual stock, you can choose to sell it at any time during the trading day (that is, while the stock market is in operation), and you will get the price that’s current at the moment you sell. When the stock market, or a particular stock, is very volatile, your selling price can change significantly throughout the day.
For example, the stock of an individual company may start the trading day at a price of $40.00 per share, rise to $45.00 by the middle of the day, and then fall to $37.50 by the end of the day. A simple calculation shows how time can affect the amount of money you may make from selling 100 shares: from an early morning $4,000, to an afternoon $4,500, to a day’s end $3,750.
When you want to redeem (that is, sell) shares of a mutual fund, the time of the day when you submit your request (by phone, fax, Internet, or mail) doesn’t matter. Although the net asset value (NAV) of the fund may rise and fall throughout the day, you always end up receiving a check based on the closing price for the end of the trading day (4 p.m. Eastern time). If you want to be relatively certain of the NAV at which your shares will be redeemed, place your sale order at or near the end of the trading day. That way, you know that the price quoted over the phone will probably be the same, or almost the same, as that day’s closing price.
Another disadvantage to mutual funds is that stock funds (also called equity funds) are not very “tax-efficient.” Here’s how this inefficiency plays out in your overall investment picture:
When you own individual stocks, you decide when to buy and sell them.
When you sell a stock that has increased in price, you receive a type of profit known as a capital gain. At the end of the year, you must pay taxes to the IRS on all the capital gains you enjoyed during that year. But with mutual funds, the schedule of stock purchases and sales is up to the fund manager —you don’t have control of the timing.
Fortunately, there are funds managed specifically to minimize tax inefficiency. I explain how this works in Chapter 9. Many stock investors carefully regulate their sales of stock so that they incur capital gains when the additional money is less burdensome to their tax situation. For example, a stock investor might choose to realize her capital gains during a year when her salary from work is smaller, thereby reducing her overall tax rate.
Mutual fund investing, however, means that you may receive capital gains distributions from the fund at any time. Of course, you end up paying taxes on these at the end of the year. At tax time, mutual fund firms send out copies of Tax Form 1099-DIV to their mutual fund investors. The document details taxable earnings. Don’t fail to report this income on your return; the fund company is also reporting it to the IRS, which will check for discrepancies.
If you are in a high tax bracket — that is, if your overall income is large enough to make your federal tax rate burdensome — and if you have a significant amount of money to invest in the stock market (say, $25,000 or more), you may want to consider investing in individual stocks rather than mutual funds so that you can better control the tax effects of your investments.
Unlike your deposit in a bank, credit union, or savings and loan association (S&L), your investment in a mutual fund is not insured by the Federal Deposit Insurance Corporation or any other government agency. (Supervision of investment companies by the Security Exchange Commission and other organizations does not insure the value of your investment.) Therefore, when the fund invests in securities that rise and fall in value, you have the possibility of losing your initial investment.
In some states, mutual funds may be sold by banks and S&Ls or by brokerage companies associated with them and housed on the same premises. Read the fine print, and don’t be confused. Although you may make a mutual fund investment over a counter in your local bank, your money will not be insured the way a bank deposit is. Walk, don’t run, from any banker who implies the opposite.
Sometimes funds are managed in ways that contradict the image presented in advertising or promotion. A fund that is touted as a conservative fund — one that selects investments so as to minimize risk and volatility — may be managed in an aggressive manner, putting money into highly volatile small-company stocks, for example.
A fund that calls itself a stock fund may actually keep a sizeable portion of its investment money in cash or in short-term government bonds, which are considered equivalent to cash; thus, it may miss out on some of the gains enjoyed during a strong period for the stock market.
Instead of relying solely on advertising, press accounts, or the advice of a broker, always ask for a prospectus before investing in a fund. This is a detailed description of the fund and its investments, written according to government guidelines. Compare what you read in the prospectus with the sales pitch presented in ads or by a broker. If you feel there’s a contradiction between them, don’t hesitate to ask about it.
