Index Mutual FundsIndex mutual funds offer a convenient means of assembling a well-diversified portfolio of mutual funds without having to spend a lot of time and effort on the selection of individual funds. And you'll find that there are index mutual funds that track most of the major stock, bond and commodities indexes, plus many market sector indexes, thus including most of the asset classes needed for a well-diversified portfolio, domestically and internationally. Indexes are theoretical "baskets" of securities that are designed to reflect the performance of some segment of the securities markets. Indexes can be evenly weighted, such as the Dow Jones Industrial Average, or capitalization weighted, such as the S&P 500. There is no entity that actually owns the securities that make up an index, thus the performance of the actual indexes does not include any transaction costs. The prices of the securities in the indexes are aggregated daily and published, thus providing benchmarks or baselines that are used as a proxy for the performance of the market segments they track and to evaluate the performance of securities and investment portfolios that are similar in composition to the indexes. Index mutual funds that track equally weighted indexes may own all of the securities that comprise the indexes they track. But Index mutual funds that track capitalization weighted indexes rarely, if ever, own all of the securities that comprise the indexes they're designed to track. Rather, they use statistical sampling techniques to assemble portfolios that include representative subsets of the indexes that have a very high probability of approximating the performance of the indexes. The reason that they employ this technique is that the transaction costs of constantly buying and selling shares of all the securities in an index would be so great that the performance of the funds would significantly lag that of the indexes. For instance, the stocks that make up the S&P 500 are constantly changing and weighting of those stocks also changes, usually on a daily basis. The transaction costs of maintaining a portfolio that was a mirror image of the index would be prohibitive. Statistical sampling is a sound science and has worked well for the index mutual funds that use it. These funds generally have done an excellent job of tracking their indexes but their performance still tends to lag that of their indexes by a fraction of a percent due to transaction costs, even though those costs have been minimized by the use of statistical sampling, and management fees, although they're extremely low relative to traditional mutual funds.. There's quite a bit of controversy regarding the efficacy of index mutual funds. Some, like John Bogle of Vanguard, strongly advocate the use of index funds. Others, like most of the managers of actively managed mutual funds, insist that investing in index funds is a sure way to achieve mediocre performance. Both sides have some valid arguments. The proponents of indexing point out that 80% of all actively managed mutual funds fail to beat their benchmark index in any given year and that index mutual funds have very low management fees, usually in the neighborhood of 0.20% to 0.25% per year. As management fees are deducted from returns, lower management fees translate to higher returns. An individual investor would have to select actively managed mutual funds that consistently beat their benchmark indexes by at least the difference in management fees to justify owning actively managed funds rather than index funds, and the average individual investor has missed that target by a long shot. Some proponents of indexing like to point out that the average mutual fund investor's long-term average return is only slightly greater than the return on T-Bills, which are a riskless investment. This is probably due to the fact that many mutual fund investors do not know how to assemble a portfolio of funds that work well together and/or do not embrace a buy-and-hold strategy. Indeed, many mutual fund investors chase returns or sell after the market plummets and buy after prices have risen significantly, all of which will guarantee poor returns. Those who advocate actively managed mutual funds over index mutual funds tend to have a vested interest in actively managed funds or are investors who have done well over the years by investing in actively managed funds. As noted above, proponents of indexing like to point out that you can only expect mediocre performance from index mutual funds, and that's probably so on average. But not all investors are average and investors who are successful at selecting actively managed funds that consistently beat their benchmarks by at least the difference in management fees will realize better than mediocre returns. What do I think? Well, it depends. Index mutual funds are definitely a good option for at least the core of your portfolio. And you may want to use them exclusively, especially if you don't have the time, knowledge, confidence, interest and discipline required to assemble, monitor and manage a portfolio of actively managed mutual funds. However, not all of the asset classes that can provide good diversification to your portfolio are available as index funds, but enough of the asset classes are available as index funds to assemble a well, but not fully, diversified portfolio. Many of us like to think we're good enough to beat the indexes or we just like the challenge posed by selecting actively managed funds or we feel the opportunity to get better returns exists and we're willing to take the risk and expend the effort required to meet that challenge. I wouldn't discourage anyone from using a pure indexing strategy, it's a pretty good strategy. But I firmly believe the opportunity to do better exists and that it's achievable by those who are willing to acquire and use the knowledge required to meet that challenge. Diversified domestic stock index mutual funds that cover the total market or various segments of the market are the most common index funds and some of the largest mutual funds are diversified domestic large-cap stock index mutual funds. You can use index funds to participate in just those segments of the market in which you're most comfortable or to deliberately over-weight your favorite segments. You'll find index funds that track the following U.S. stock market segments, all of which are market capitalization weighted except the Dow Jones:
A well diversified portfolio of index mutual funds that work well together to provide the maximum return for the level of risk you are comfortable with is a good alternative to a portfolio of actively managed mutual funds for those of you who don't have the time or desire to do due diligence on a universe of actively managed funds in an attempt to beat the indexes. Return to the top of Index Mutual Funds. Return to the Various Types of Mutual Funds. Go to the next section, Investing Basics.
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