Frequently Asked Questions About Index Investing
What Investors Should Know About Investing in Index Funds
Do you have questions about index investing? Maybe you're wondering what an index is. Or perhaps you want to know about the benefits of investing in index funds and which index funds are the best.
The answers to what you want to know (and questions you never thought to ask) about how to invest with index funds are all here. Reviewing frequently asked questions about index investing can help both beginners and experienced investors understand the basics about index funds and also how to learn new things for greater investing success.
Index Investing FAQs and Resources
For your convenience and further reference, each question has a hyperlink to more information for more depth and greater understanding to the answer to the question. If you want to read more, simply hover over the question and click the link!
An index, with regard to investing, is a statistical sampling of securities which combine to represent a defined segment of the market. For example, the S&P 500 Index is a sampling of approximately 500 large capitalization stocks. The index itself is not an investment; indexes (or indices) are created to use as reference points or benchmarks to gauge a particular segment of the market. Investors and portfolio managers can compare the performance of their own investment portfolios against an index, with the hopes of outperforming the index.
Many mutual fund companies create index funds to mimic the performance of a particular index.
Examples of other indexes include The Wilshire 5000 and the Russell 3000, both of which have been called total stock market indexes, The Russell 2000, which represents small-cap stocks, The Barclays Capital Aggregate Bond Index, which is a total bond market index, and various forms of The MSCI Indices, which represent international stocks.
What Is the Dow Jones and How Do Investors Use It?
The Dow Jones Industrial Average is an index that represents the average price movement of 30 large companies from various industries in the United States. Named after Charles Dow and Edward Jones, the famous stock benchmark is also known as Dow Jones, the Dow 30 or as it is most often called, "The Dow." Perhaps because of its recognizable name, evening newscasts and widely read print media can simply provide a headline, such as "The Dow Hits Record Highs" and consumers of information will know what that means. However, the Dow is primarily for reference. While most serious minded investors may respect its psychological "headline" impact, the Dow's use as an investment vehicle is not commonly sought because of its narrow exposure to such a small amount of stocks.
The answer to this question can be answered with a few follow-up questions: If everyone wants to beat the index, why not simply invest in an index fund? Can it be wise to play 'not to lose' to the market rather than playing to win and increase the risk of losing? There are many specific reasons to invest in index funds. One primary reason for investing in index funds is that they are passively managed, which means that the fund manager is not actively trying to beat the market or any particular segment of the market; they only seek to match the index performance (or come close to matching it after expenses).
This passive management yields other reasons or advantages to investing in index funds, such as low expense ratios and tax-efficiency. Due to these advantages, and over long periods of time, such as 10 years or more, index funds often outperform the majority of actively-managed funds.
Index funds can be a wise choice for most investors and the most widely used index funds are those that replicate the S&P 500 Index. But which are the best? S&P 500 funds are generally identical in that they all invest in approximately 500 of the largest US companies, measured by market capitalization. Therefore the best S&P 500 index funds, such as Vanguard 500 Index (VFINX), Fidelity Spartan 500 Index (FUSEX) and Schwab S&P 500 Index(SWPPX), are those with the lowest expense ratios.
Indexes that are said to capture the total stock market include The Wilshire 5000 Index and The Russell 3000 Index, which respectively represent approximately 5000 and 3000 US stocks. Index funds that do a good job of replicating these indexes, while keeping the crucial expense ratios low, include Vanguard Total Stock Market Index (VTSMX), Schwab Total Stock Market Index (SWTSX) and iShares Russell 3000 Index (IWV), which is an Exchange Traded Fund (ETF).
The total stock market index funds that seek to replicate these indexes offer investors broad exposure to large-cap stocks, mid-cap stocks and small-cap stocks. However, investors should not assume that bigger is better in terms of diversification. Because these total stock market index funds are market weighted, which means the large-cap stocks comprise a majority of the index, the performance is almost identical (see R-squared) to the S&P 500 index. In other words, an investor may be better off using one of the best S&P 500 Index Funds and then build around this core with different fund categories for true "total" stock market representation.
An Exchange Traded Fund (ETF) is similar to an index mutual fund in that it holds a basket of securities that will seek to replicate a particular index. The primary difference is that ETFs trade like stocks, which means their price will fluctuate throughout the day, whereas mutual funds only trade at the end of the day at a Net Asset Value.
For the average investor, index mutual funds are as good as (or better than) ETFs because the primary benefits (i.e. low expenses, passive nature, broad market exposure, and simplicity) are the same with both. Some investors use ETFs for greater flexibility in navigating market fluctuations but the increased trading will also increase transaction fees.
Many index investors are proponents of Efficient Market Hypothesis (EMH). The hypothesis essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities and, therefore, no amount of analysis can give an investor an edge over other investors. Simply put, index funds can be considered the "if you can't beat 'em, join 'em" investment choice.
Other index investors may not necessarily support what EMH says, but they still do not believe the extra time and resources required to be successful with stocks, bonds, and/or actively-managed mutual funds is worth the added effort. Therefore, the vast majority of index investors either do not believe an edge over other investors is possible or, assuming the market can be beaten with skill, the index investor simply does not want to do the research required to outperform the major market indexes. "Going with the flow" of markets can be easier and more beneficial than going against it.
After you have completed the preliminary planning stages of gauging risk tolerance and forming an appropriate asset allocation, you may begin building the portfolio. A common mutual fund portfolio structure is called Core and Satellite, where an investor will choose a core holding and build around the core with other funds (the satellites). An ideal core holding is a large-cap stock index, such as one of the best S&P 500 Index Funds, with the satellites consisting of other fund types representing various mutual fund categories and/or sector funds. You may either use all index funds or a combination of index and actively managed funds. Note: In either case, an S&P 500 index fund is likely best for the core.
Sector Funds focus on a specific industry, social objective or sectors such as health care, real estate or technology. Their investment objective is to provide concentrated exposure to specific industry groups, called sectors. Investors do not need sector funds for appropriate diversification but they can help minimize risk and maximize returns if used properly.
In today's expansive universe of index funds and ETFs, an investor can gain narrow exposure to almost any industry sector and some sub-sectors that can be imagined. For example, if you wanted to buy shares of a health sector index that covers a broad spectrum of health stocks, you could buy shares of T. Rowe Price Health Sciences (PRHSX) or, if you want to invest in foreign stocks, specifically in the country of India, you could buy shares of the ETF, S&P India Nifty 50 Index (INDY).
However, investors should be careful with sector funds because there is increased market risk due to volatility if the sector suffers a downturn. Over-exposure to one sector, for example, is a form of market timing that can prove harmful to an investor's portfolio if the sector performs poorly. In general,a good use of sectors is to add 3 or 4 different sectors to a portfolio, each with low correlation to the core index, representing approximately 5% of the portfolio.
Some statistical measures, such as Alpha (which helps reveal how an actively managed fund's manager adds value), does not really apply to index funds because they are passively managed. Other measures, such as R-squared (R2), however, can be useful. R2 is a statistical measure that investors can use to determine a particular investment's correlation with (similarity to) a given benchmark. The benchmark is an index, such as the S&P 500, that is given a value of 100. A particular fund's R-squared can be considered a comparison that reveals how similar the fund performs to the index.
If for example, the fund's R-squared is 97, it means that 97% of the fund's movements (ups and downs in performance) are explained by movements in the index. R-squared can help investors in choosing the best funds by planning the diversification of their portfolio of funds. For example, an investor who already holds an S&P 500 Index fund will want to be sure that other funds they add to their portfolio are not too similar. This ensures greater diversification. Imagine if you had 5 stock funds in your portfolio and you were not aware that all of them were so similar that they would perform almost identically. This would not be a welcome discovery if your funds all declined in value along with the market. To prevent this, you can check to be sure that the R-squared is significantly lower than 100%.
Index funds are said to be "tax-efficient," which means that, when held in a taxable account (something other than a tax-deferred account, such as an IRA or 401(k)), index funds typically generate less in capital gains distributions than actively-managed funds. Index funds have low turnover, which means the rate at which the holdings are bought and sold withing the fund is much lower in with index funds in comparison to actively managed funds. Using index funds in taxable accounts can be considered something called asset location -- choosing the best account type (location) for particular funds. Mutual funds that generate more dividends and capital gains are best held in tax-deferred accounts, such as IRAs, 401(k)s and certain annuities. Exchange Traded Funds (ETFs) can also be wise choices for tax efficiency.
If you plan to use index funds exclusively, you may want to go directly to one of the best mutual fund companies for index funds, such as Vanguard or you may do more research and analysis at a site, such as Morningstar These research sites will typically highlight many features you've seen in the index fund investing FAQ. As a reminder, look for index funds with the lowest expense ratio, low turnover ratio, appropriate number of holdings, low tax cost ratio and the fund category. And when you decide to add other funds, you'll want to be sure that the R-squared is not too close to 100 (the lower the number, the lower the correlation to the index and thus the greater the diversification).
About Money does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.