Thumbing Through Index Funds

Experts Recommend Indexing for Novice Investors

By Kara Stefan

John Bogle, founder and former chairman of The Vanguard Group of mutual funds, is a big proponent of index funds. “Because the index fund makes for a brainless and respectable choice, it’s really our first-stop recommendation to investors of all kinds, novice and experienced,” says Bogle.

“Factor in convenience, performance, low expense, and simplicity, and these things beat the pants off the two traditional options: brokers and mutual fund managers.”

This just goes to show you that you don’t have to know everything to create a solid investment plan. Millions of investors have planted their money in actively managed mutual funds, only to get beaten by the indexes over the past 10 years. If you don’t want to spend a lot of time researching your investments–or even if you do–indexing is an excellent way to go.

Buying into a Benchmark
When you hear references to the Dow Jones or the S&P 500, you’re hearing the names of indexes, or benchmarks, which help give investors a broad idea of what’s going on in the markets. The S&P 500, for instance, is comprised of the top performing 500 blue chip stocks, and its daily average is often cited as a reflection of the blue chip market.

Indexing is a strategy designed to match the performance of a particular benchmark. An index fund will basically maintain the same positions as a particular index, so its performance typically shadows the index’s returns. It’s basically a way for individual investors to purchase a piece of the overall market.

Reasons to Index

Performance: Naturally, hindsight is 20/20, but what we now know is that despite the impressive returns that stock mutual funds have experienced over the last decade, index fund investors still came out on top. In fact, the 10-year total return (ending 12/31/98) for the Wilshire 500 Equity Index was 17.80%, as compared to 15.22% for the average general equity fund.
Management: One of the most obvious advantages to indexing is that you don’t have to pay out exorbitant fees for some big-name money manager. All it takes is a computer to crank out returns and buy and sell any new securities that either drop off or are added to a particular index, so expense ratios are extremely low in comparison to actively managed funds.
Taxes: A major criticism about actively managed mutual funds is that you’re unable to control your tax liability. If your money manager decides to sell a highly appreciated stock he’s held for less than a year, you and all the other fund shareholders are left holding the capital gains tax bill. Not so with an index mutual fund. There’s minimal fluctuation among securities included in indexes, which translates to far less trading and, consequently, a lower tax bill.
Risk: You still encounter market risk with index funds, but you avoid money manager stock pick slumps. In short, index investors can sleep more easily at night.
Diversification: When you hear the recent performance numbers from index funds, they’re usually talking about large cap stocks. And it’s true that an index fund that tracks the S&P 500 or Wilshire 5000 encompasses a large, well-diversified mix of stocks. Note, though, that we’re talking about diversification across a single asset class.

To further diversify your index strategy, you’ll want to invest in one or more index funds representing different asset classes, such as large cap stocks, small cap stocks, international securities, bonds, or money market instruments.

One of the easiest and most convenient ways to get started is on the Web. A new site at www.whatifi.com specializes exclusively in placing investors in a variety of index fund choices to suit their individual needs and goals.

A popular part of the site is its “What if I…” feature that calculates various investment scenarios. For example, what if 10 years ago, you had started putting aside the money you would otherwise spend on dining out once a month and instead invested it in the stock market’s S&P Index. How much would that investment be worth today? Answer: $12,610.

Just in case you’re not thoroughly convinced that indexing will deliver the returns you want, try this “what if” scenario for size. If you had invested $10,000 fifty years ago in the average managed mutual fund, you would have netted about $2.59 million. Had you gone the indexed route, you would have earned approximately $5.2 million–more than twice as much.

For a novice going head-to-head against professional money managers, that’s not a bad return on your investment.