Indexed Mutual Funds

INDEXED MUTUAL FUNDS

In a world of complex investment products, one of the easiest to understand may also be appropriate for a variety of individual financial objectives. The appropriateness of an investment depends on personal goals but many individual and institutional investors have turned to index investing, a strategy that attempts to approximate the performance of a broad market index.

As an investment strategy indexing began in the early 1970s in the United States, when large institutional investors used it as a low-cost way to achieve competitive, long-term performance for retirement and other investment programs. The index fund concept was pioneered by Vanguard Funds. More recently, index funds have gained popularity among individual investors as a relatively conservative approach to stock market investing.

Investment professionals emphasize the importance of including stocks in any individual long-term strategy because of their historically better performance compared with other investments and inflation. Most of the investors believe that stocks are “efficiently priced,” meaning that their prices reflect all relevant information, so that it is difficult to consistently outperform the market through active management. Therefore, a mutual fund that seeks to reflect the market rather than to beat it can be an easy and cost-effective way to gain broad equity exposure.

By definition, indexed mutual funds cannot outperform the market. However, the funds cannot give you the same returns as the market index they track either. Because there are some fees and expenses related to the index funds.

In 1884 Charles H. Dow, first editor of The Wall Street Journal and founder of the Dow Jones Company, originated the concept of measuring a stock market’s performance with an index of securities by calculating an average that was the predecessor to the Dow Jones Industrial Average. Over the years, a huge number of indices have developed, including the Standard & Poor’s 500 Stock Index, which was established in 1957.

These days, most of the money invested in index funds tracks S&P 500 Index. Known as the standard for measuring large-cap U.S. stock market performance, this index includes a representative sample of leading companies in leading industries. It is a market-value weighted index and each stock’s weight in the index is proportional to its market value. The S&P 500 is used by 97% of U.S. money managers and pension plan sponsors. It represents about 80% of the total market value of all U.S. common stocks. More than $1 trillion is indexed to the S&P 500.

While the S&P 500 is the most popular benchmark for index funds, there are other benchmarks that measure the performance of different market segments. The Wilshire 5000 Index, for example, represents more than 7,000 regularly traded stocks of U.S. companies.

Another broad-based index is the Wilshire 4500 Index, which consists of all the Wilshire 5000 stocks except those that are members of the S&P 500. This equity index represents all small- and mid-cap stocks in the United States of America. More focused small- and mid-cap indices include the Russell 2000, the S&P 600 SmallCap, and the S&P 400 MidCap.

Basically, there are two types of indexing strategies: full replication and sampling. A strategy in which a fund manager attempts to invest in weighted holdings of every stock in an index is called a full replication, whereby a sampling is when a manager invests in a smaller group of stocks that is representative of the broader index.

The majority of indexed mutual fund managers attempt a full replication strategy, however some use a sampling strategy when it is too costly or/and awkward to attempt a full replication of a targeted large index, such as the Wilshire 5000. Despite the fact that indexed mutual funds track the performance of their benchmark indices, they are still likely to underperform slightly for two reasons. First, index funds have fees and transaction costs that are deducted from net assets, while indices have no expenses. Second, index funds usually have very small cash positions, while on the other hand, indices do not.

Index funds are “passively” managed, meaning that management of the investment portfolio does not require day-to-day selection and evaluation of individual stocks. Rather, the index fund manager’s main job is to replicate the index by adjusting individual stock weightings based on the fund’s cash flow. In contrast, active fund manager attempts to outperform the market benchmark through careful selection of industries or individual companies that he/she believes are prepared to achieve the mutual fund’s overall objective.

Fundamentally, index funds are widely diversified (with some exceptions). An S&P