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The ABCs of Index Funds and ETFs

June 2011

Lab Rat

A Little History

Until recently, most mutual funds were actively managed: that is, a team of money managers and analysts would scour the investment universe for stocks, bonds or other assets that seemed to them to either offer exceptional value (value investing) or unusual potential for growth (growth investing) or that met other investment criteria, such as generating predictable income.

In 1951 a Princeton undergraduate named John Bogle wrote a thesis questioning whether active management can really add value for ordinary investors. Then in 1976 Bogle, building on new computer technology and on theoretical work by Eugene Fama, Burton Malkiel and Paul Samuelson, launched a low-cost mutual fund designed to passively replicate the S&P 500 index (a mathematical model that tracks the price of stocks issued by 500 of the largest US companies).

Bogle’s fund—and the entire idea of passive or index investing—was denounced as “un-American.” Thirty-five years later, index investing has become one of the most popular, useful, but also misused and misunderstood investment strategies in America.

The Goals of Index Fund Investing

At its purest and most logical, an index fund replicates a very broad slice of a particular market such as stocks issued by large US companies. The index fund manager buys the stocks or bonds that make up the index and holds them passively making as few changes to the portfolio as possible. Ideally, index funds are extremely low cost (0.30 percent annual expense ratio or less) and the funds do very little buying and selling of individual stocks or other assets (a turnover ratio of less than 10–15 percent per year). The low cost ensures that investors keep most of the dividends or interest income, while the low turnover generally reduces taxes and hidden trading costs.

How Index Funds Work

Most index funds start with an index creator: usually a company that specializes in developing the mathematical and statistical models that define the index.

The Wilshire 5000, for example, attempts to track the stock prices of almost all of publically traded US companies with sizes ranging from giant multinationals like Exxon Mobil to small companies such as Green Mountain Coffee.

Other indexes select a smaller group of companies designed to represent of a portion of the market. For example, to construct the S&P Small Cap 600 Series, Standard & Poors’ Index Committee chooses a group of about 600 companies with a range of industries and company sizes representative of a broader sample of smaller US companies,.

Most indexes are “market capitalization weighted”. The market capitalization (or “market cap”) of a company is equal to the price of a share of a stock issued by the company multiplied by the number of shares outstanding. In a market capitalization weighted index, the largest companies will make up the biggest proportion of the index and will have the most effect on whether the price of the index rises or falls. In addition, as the price of a particular company’s stock rises, it will make up a bigger proportion of the index.

Here are five major companies that specialize in index creation:

To construct an actual Index Fund into which investors can put money, the index is licensed to one or more money management firms whose job is to create the fund, market it and oversee the pool of assets. Among the major index fund managers:

Index Mutual Funds vs. Index ETFs

Index funds come in two basic varieties: classic open-end mutual funds (hereafter referred to as index mutual funds) that are priced at the close of each business day; and exchange traded funds (or ETFs), that trade all day like stocks on exchanges such as the New York Stock Exchange (NYSE). Index mutual funds are most useful for investors who want to add small amounts to their investment every month (dollar cost averaging), while ETFs are often the best bet for investors making a single large purchase (as for example, when investing money transferred from an old 401(k) to a rollover IRA).

Researching Index Funds

Each index and the funds that use that index as a model have advantages and disadvantages. Investors should take advantage of the information provided by index creators and index fund managers to answer three key questions:

1. What does the fund invest in and what role will it play in my portfolio? (See more on the five key investment categories here.)

2. How much does it cost me to invest both in fees, such as commissions, and in ongoing management costs (expense ratio)?

3. How much do the fund holdings change from year to year (as measured by a number called the turnover ratio)?

Finally, in the world of ETFs it also makes sense to compare the trading volumes for ETFs in any category. ETFs that do not trade much can have hidden costs associated with the spread between the “bid” and “ask” prices quoted on the exchange and ETFs can sometimes trade at a significant premium or discount to the value of the underlying assets (the NAV or Net Asset Value). A look at the performance data and the trading history for an ETF can be very revealing: avoid funds that have many days when they trade more than 0.5 percentage points above or below their NAVs. Much of this information is provided on the web sites of index creators and index fund managers, but it is also essential to check the prospectus and the annual and semiannual reports for details on any fund you’re are considering.

Buyer Beware

The financial services industry always seems to know how to take a good idea to dangerous extremes. The field is now cluttered with hundreds of so-called index funds that cover extremely narrow, often highly speculative market sectors, with costs and turnover ratios as high, or sometimes higher than, many actively managed funds. There are also index funds that track broad popular indexes like the S&P 500 but that cost investors 10 to 20 times more per year than the competition. Always check the prospectus and annual reports before you buy and ask the key questions outlined above. What you don’t know can hurt you.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Outside sources used in this article are believed but not guaranteed to be accurate. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.