What's An Index Fund?

A month ago I was visiting with some clients and I had an important realization. I asked them what they knew about the investments I manage for them. They looked at each other, started to formulate about 4 different thoughts, then quickly gave up saying "nothing, we don't know what we own".

I was more embarrassed than they were. These particular clients normally read my monthly client newsletter and blog. They also ask highly intelligent questions during review meetings. In my mind, I kept asking myself shouldn't they be educated by now? After kicking myself for a few days, I started on this post.

Let's first define a fund (mutual fund, index fund, or exchange traded fund). Simply put, a fund is a group of stocks or bonds, or sometimes both, that investors buy pieces of called shares. They're the same type of shares you receive when you buy Apple stock.

An index fund is a specialized mutual fund. Index funds track indices, which are created and maintained by companies like S&P Dow Jones. You've probably heard of the S&P 500, which is designed to represent "leading companies in leading industries". For example, the S&P 500 tracks 500 large company stocks diversifed across 11 specific market sectors (utilities, financials, etc).

It's impossible to directly invest in an index. Here's where most investors get hung up. It's true. You can't actually buy an index! The rationale is indices should be free from conflict of interest.

Conflicts can arise if an organization is involved in the index publication as well as in the pricing component of funds that track the index. As such, investors normally purchase index funds from issuers such as Vanguard, iShares, as well as a few others. However, some specialty indices like those from Calvert Investments sometimes build and maintain the indices their funds track.

Index funds behave different than conventional mutual funds. Most of the stocks comprising an index at the beginning of the year are still a valid representation of the index at the end of the year. With the exception of some bond indices, there's not a lot of stocks entering or exiting on an annual basis. Conventional mutual funds are much different; they attempt to beat a benchmark (almost always an index), therefore the fund manager is constantly trading based on his assessment of perceived pricing advantages or anamolies they can profit from. You can read about whether this is a valid approach HERE if you like.

Because very few of the underlying stocks are swapped in / out each year, index funds tend to be highly efficient investments if held outside a tax deferred retirement plan like a 401(k) or IRA.

It's quite different in a conventional mutual fund. Here, frequent trading generates capital gains tax each year. The fund doesn't pay for that, you do! At the end of each year, a fund passes on all the accumulated capital gains to its shareholders in the form of a dividend.

Because an index fund isn't trying to beat a benchmark (it is the benchmark), a massive research team isn't needed to fly around the world visiting with a company's board of directors. Trading costs and manager's compensation are also major factors driving up the operational cost of owning a conventional mutual fund. A typical index fund costs 0.15-0.30% annually. A typical conventional mutual fund costs 1.00%-1.50% annually.

Exchange traded funds (ETFs) are much like index funds. Many ETFs track indices, technically categorizing them as such. ETFs are like stocks in that they trade on an exchange, like the New York Stock Exchange. Like stocks, an ETF's share price will fluctuate a bit throughout the day.

True index funds and conventional mutual funds aren't traded on exchanges like ETFs. They're priced at the end of the day by the issuing fund company. Shares are bought and sold directly from companies like Oppenheimer, American Funds, or Vanguard.

There are mutual funds that behave like index funds in that they are low cost and don't trade frequently. However, because they don't track an actual index they aren't classified that way. The best example is Dimensional Fund Advisors. Technically, Dimensional's offerings are registered as mutual funds. I'm a big fan of Dimensional for the following reasons:

• They invest in a large segment of the investable universe to capture a market like return.

• They don't trade excessively. Most of the stocks remain in the fund throughout the year.

• They are tax efficient (not a high degree of trading, remember?).

• They are extremely low cost.

To sum it up; an index fund is always a mutual fund. However, an ETF is not always an index fund. Index funds are rapidly gaining in popularity. Most financial advisors use at least a few index funds in client portfolios these days. Some advisors, myself included, have eschewed conventional mutual funds altogether.

Index funds can track all sorts of investing styles like U.S. stocks, bonds, commodities, international stocks, or real estate. Some firms, mine included, exclusively use index funds in client portfolios. Aspen Leaf Partners actually takes it one step further, specializing in the types of index funds we use in our Portfolio Designs.

You should definitely consider index funds as part (better yet all) of your portfolio. If you're not sure how you might benefit from lowering costs, greater tax efficiency, or more robust diversification please use the Shoot Me An Email form in the footer below to chat.

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