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Should I Buy an Index Fund?
If you are a small investor
Good Advice About Stock Index Funds
Investing in Index Funds Is Still the Best Choice
who wants to meet your long-term investment goals, to minimize risk and to save the time and expense of researching stocks for yourself, an Index Fund is the ideal investment vehicle.
Index Funds allow average people
to participate intelligently in the stock market. If you have only $100 to invest, you can still buy shares in an Index Fund. People invest in Index Funds because they believe that stock markets are efficient and that stock-pickers on average will not do as well as the market. When you consider that other mutual funds, those with active managers, often do not perform as well as Index Funds, you can see why many small investors buy Index Funds.
Here we answer your questions
. What actually is a stock Index? What is an Index Fund? Is an Index Fund a good investment for you? How much does it cost to buy an Index Fund? How much will an Index Fund earn for you? How do you buy shares in an Index Fund? Which Index Fund should you buy? Finally, what are the tax considerations when you buy an Index Fund?
What Is a Stock Index?
Stock Indexes are created to measure
the performance of the stock market, like the well-known S&P 500, the Dow Jones 30 Industrials, the Russell 1000 and the Wilshire 5000. A stock Index uses a list of companies and the price of the company stocks to describe how the stock market is doing. When we say that the Dow Jones Industrials hit 10,000, we mean that the combined prices of the 30 companies in that list, adjusted in a math formula, reached 10,000.
A stock Index starts with a list of company names
selected according to some established criteria. For example, the well-known S&P 500 Index is a list of 500 selected companies that make up 79% of the American stock market in terms of market capitalization.
All stock Indexes use lists
created by a board of people. The list is revised when companies merge, when company performance declines or when other conditions dictate. Companies that join the list are often selected for their growth potential. Some important Indexes of the stock markets are
- Dow Jones Industrial Index, symbol DJI
- Standard & Poor 500 Index, symbol GSPC
- Russell 1000 Index, symbol RUI, uses the largest 1000 companies that make up 89% of the stock market
- Wilshire 5000 Index, symbol WLX, has more than 5000 companies and includes 99.9% of the market
- Nasdaq Composite Index, symbol IXIC
- Standard & Poor MidCap Index, symbol MID, represents medium-sized companies
- New York Stock Exchange Composite Index, symbol NYA
Yahoo Finance is an excellent resource for information on stock Indexes. It has a list of the major stock Indexes of the world here, along with the companies included in each Index and performance charts. Yahoo also provides historical Index values over the years.
What Is an Index Fund?
An Index Fund is a mutual fund. You buy shares of an Index Fund, just like any mutual fund. However, an Index Fund invests only in the stocks of the companies in the Index. The performance of the Index Fund is designed to match the performance of the Index it tracks. For example, if the Dow Jones Industrial Index rose 5% this month, the value of your shares in the DJI Index Fund also rose just about 5%, too.
An Index Fund is a mutual fund that buys the stocks of companies in the Index, and holds them in its portfolio. The Index Fund is set up to mirror the performance of the stock Index, by holding all the stocks in the Index, in the same proportions as the Index. The investment goal of Index Funds is to achieve the same results as the Index it mirrors. An Index Fund turns in an average performance, rather than trying to hit the ball out of the park. When you buy shares in an Index Fund, you can expect to make average results.
Like all mutual funds, Index Funds are a diversified investments, because they hold a large basket of different stocks. If one of the stocks in the basket doesn’t perform, the gains of the other stocks will probably offset its loss. Diversifying your investments lowers your risk. When you buy an Index Fund, your investment is diversified.
How to Buy Shares in an Index Fund
All Index Funds perform approximately the same for the same Index. That is their goal.
The best-known Index Fund is the Vanguard 500 from The Vanguard Group, which began in 1975 to track the S&P 500 stock Index. Many stock brokers have set up their own Index Funds, so there are thousands of Index Funds to choose from. Before you buy an Index Fund, you must decide which Index you prefer, an Index of large companies, an Index of many companies, or even an Index of foreign companies. You should also choose an Index Fund with a low expense fee.
Advantages of Buying an Index Fund
The advantages of investing in an Index Fund are simplicity, better diversification, lower risk, good liquidity, lower fees and lower distributed capital gains.
- Better Diversification. According to the theory of market efficiency, you'll benefit in an Index Fund, no matter how the market values each company stock. If you don't believe in market efficiency, that's okay, too, since the Index is still a diversified basket of stocks. The stock of one company might become worthless, while the stock of another company skyrockets. But, on average, the Index Fund is most likely to deliver modest gains.
- Lower Fees. Other funds charge annual management fees for picking stocks. Index Funds are passive funds and have no fund managers. The expense fee is also lower, too.
- Good Liquidity. Like all mutual funds, Index Funds are extremely liquid. You can buy shares at your convenience and redeem your shares whenever you need the money. The minimum investment is usually less than $1,000.
- Fewer Distributed Capital Gains. When a U.S. mutual fund sells stocks at a gain, it is required to distribute the capital gains to its shareholders. Funds usually distribute their capital gains once a year. You receive no cash, but your number of fund shares is increased to reflect the distribution. The shareholder must report and pay income taxes on the capital gain, even if your shares have lost money. Because Index Funds do not buy and sell stocks very often, there are often no distributed capital gains. This means that you save on income taxes and that your tax savings can remain fully invested and earning for you.
- Tax Considerations of Index Funds. When you redeem your shares in an Index Fund, you will report the investment gain or loss with your other capital gains on Schedule D of your federal income tax return. However, if you buy shares of an Index Fund with the money in your tax-sheltered IRA or 401(k), you pay no income taxes when you redeem your shares in an Index Fund or when the fund makes a capital gains distribution. This is the case for any investment you buy for your IRA or 401(k).
Disadvantages of Buying an Index Fund
If your goal is to hit it big in the stock market, Index Funds are not for you.The disadvantage of buying an Index Fund is that you will not earn outstanding profits. On the other hand, you will not suffer losses that are worse than average. Your investment return will be average, and will reflect what most of the stock market does as a whole. You can be sure that your investment will do as well as the stock Index, and no better.
As I said, we buy Index Funds because we believe that stock markets are efficient and stock-pickers on average will not outperform the market. There is an interesting paradox in this way of thinking, called the Grossman and Stiglitz paradox. If everyone believes that markets are efficient and, therefore, does no stock picking, in the long run markets will not be efficient.
Notwithstanding these disadvantages, an Index Fund is an excellent way for the investor to participate in stock markets and realize long-term investment goals.
What Are the Charges When I Buy an Index Fund?
If you buy your Index Fund shares from the fund managers, there are generally no other charges, no sales commission, no front-end load fee, and no rear-end load. All of your invested money is put right to work for your benefit.
But you will pay an annual expense fee. When you choose an Index Fund, compare the annual fee it charges you. All funds have operating expenses. Because an Index Fund is not actively managed, its fee is significantly less than other mutual funds. The annual fee is often less than .5% of its assets under management. That means your investment fee is one half of one percent of your money each year. Once a year, the fund automatically collects this fee from your account by reducing the number of fund shares you own by .5%.
How Much Does a Share of an Index Fund Cost
The price of a share in an Index Fund is its Net Asset Value, NAV. At the end of each day, the value of the stocks owned by the fund is computed, plus cash held, minus unpaid expenses. The result is Total Net Assets. The total is divided by the number of shares of the fund owned by investors like you. The result is the NAV, the price you pay to buy one share of the Index Fund. The daily NAV of all funds is published in the financial section of many newspapers, as well as on the Internet.
DO NOT COMPARE Index Funds on the basis of their NAV. It is not a factor in your purchase decision. NAV is simply a relative measure of fund performance. If you invest $1,000 in a fund with a NAV of $100, you will receive 10 shares. If you invest $1,000 in a fund with a NAV of $200, you will receive 5 shares. Either way, your investment is worth $1,000. When the stock Index increases 5%, the NAV increases 5%, and your investment will increase 5%, too. Many new investors misunderstand this.
How Much Money Will I Make if I Buy an Index Fund?
The stock markets were hit brutally in 2008. But past performance is no predictor of future performance. Investors should know that, after the annual fee is subtracted, their rate of return will not exactly match the market return of the Index. However, it should be very close. Because of the annual expense fee, and because of the “tracking error” of all Index Funds, your shares could earn slightly less than the Index. Here's how the Dow Jones Industrial Index has performed in recent years.
- At 12/31/04, the DJI was 10783
- At 12/31/05, the DJI was 10718, down 0.6% for the year
- At 12/31/06, the DJI was 12459, up16% for the year
- At 12/31/07, the DJI was 13261, up 6% for the year
- At 12/31/08, the DJI was 8772, down 34% for the year
- At 9/14/09, the DJI was 9598, up 9% year to date
What Is Tracking Error in a Index Fund?
It is impossible for your Index Fund to mirror the Index exactly for several reasons. The fund must keep some cash on hand for redemptions, and the fund cannot buy all its stocks the minute an investor sends cash. Occasionally, when the Index adds or drops companies, the Index Fund has to redistribute its portfolio and may suffer a loss in the action. The small difference between the Index performance and the fund performance is known as the “tracking error.” Tracking error can be positive or negative. A well-run S&P 500 Index Fund should have an annual tracking error of no more than 5 basis points, which is .05%, or $5 out of a $10,000 investment. All in all, the cost of tracking errors are minor compared to the fees of other managed mutual funds.
How Do I Buy Shares of an Index Fund
It’s easiest to buy the shares directly from the broker or mutual fund company that manages the fund. Once you’ve chosen a fund, the website will have details to open an account and send your money. Selling your shares is called “redeeming” them. You can request a full or partial redemption of your shares by telephone, by letter or on the fund website. It usually takes about five business days to receive the money.
As an option, many Index Funds offer automatic investments, and will debit your checking account for regular monthly purchases.
An ETF is Another Way to Buy a Stock Index
Another convenient and cost-effective way to own shares that behave like a stock Index is to purchase shares of an ETF. An ETF, Exchange Traded Fund, is a security designed to track a specific stock Index. ETFs are bought and sold on a stock exchange, just like shares of stock. One well-known ETF is called the Dow Diamonds, symbol DIA. It is a trust representing all 30 stocks in the Dow Jones Industrial Average. Another ETF is the SPDRs, also called spiders or spyders, symbol SPY. This exchange-traded fund tracks the performance of the S&P 500.
Like an Index Fund, an ETF is a trust with a portfolio of stocks that track an Index. However, unlike an Index Fund, an ETF trades on a stock exchange. So you can buy shares in an ETF through your online broker, the same way you buy stocks. Often two prices are quoted for an ETF, a bid price if you are going to sell , and a ask price if you are going to buy. Brokers commission also applies. Diamonds, Spyders and all other ETFs are bought or sold on the open market just like a regular common stock.
This information is not intended as financial or legal advice. Consult your lawyer or registered financial advisor for your personal recommendation.
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