Intro to Mutual Funds: Index Funds

Before I delete the GRS forums, I’m moving the best posts here. Last month I shared Vintek’s introduction to mutual funds. Here he explains index funds.

In my previous discussion of mutual funds, I mentioned index funds:

Along came index funds, and this was hailed as the ultimate in investing. You’d invest not in just a basket of stocks, but in the entire market. Since the manager wasn’t required to do research and pick stocks (all he had to do was buy it all and hold it), his fee was reduced to a fraction of an actively managed fund’s fees (about 0.2%). Yes, you could have years of losses (2000, 2001 and 2002 were the most recent), but studies show that the market always recovered, even if some of the companies in the index didn’t. If you wanted put your investing on autopilot and be assured of a long-term (any 20 year period since the 1920s had an average gain of 10% per year) winner, this was the way to go.

That’s the basic introduction. Now let’s talk about what it all means.

What’s an index?
In most cases, an index is just a group of financial instruments (mostly stocks, but also bonds, REITs and other things) designed to represent something. The index is typically used as a baseline against which a person’s investments can be measured. For example, the S&P 500 is supposed to be the 500 biggest stocks on the market, per Standard & Poor. The DOW is a collection of 30 stocks that are supposed to represent American industry as a whole. The Wilshire 5000 is supposed to represent all of the stocks currently being traded over the stock market. Ditto the Russell 3000. Interestingly enough, the Russell 3000 is broken into two parts: the Wilshire 1000 (kind of the Wilshire counterpart to the S&P 500), composed of the biggest 1000 stocks on the market, and the Wilshire 2000, composed of everything else.

What’s an index fund?
An index fund is exactly what it sounds like. It’s a fund that’s designed to follow an index. For example, if you bought into an index fund that tracked the S&P 500, you’d be buying into every stock listed in the S&P 500. Because that fund covers the largest of the stocks (by capitalization) on the market, it would be considered a large-cap fund index fund. By contrast, a fund following the Russell 2000 would be considered a small-cap index fund. The really interesting thing is that the large caps stocks are so big that they overwhelm everything else by comparison. For example, if you singled out the companies that comprise the S&P 500, they would comprise about 70% of the Wilshire 5000! 70%!

What makes an index fund such a good choice?
Good question. Well, we know that the market always recovers from downturns and goes up in the long term. Stocks and (managed) funds don’t always recover. We know that if we hold an index fund, there won’t be a lot of trading because a manager won’t be jockeying for the best performing stocks. He’d just hold stocks according to the index. As a result, this keeps trading costs (and therefore expenses) on the fund low. Furthermore, an index fund is tax-efficient because it doesn’t trade much. If it doesn’t trade much, you won’t have to pay very much in capital gains taxes. Still, there is a small amount of trading every year, as most indexes are re-evaluated on an annual basis.

That’s it for now. In the future, I’ll talk a bit about market capitalization (big cap vs. mid-cap vs. small cap) and why it’s important to know the difference. I’ll also talk about what index funds I own and why I own them.

Thanks to Vintek for allowing me to repost this information.

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