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Choosing an Index FundIntroduction
Index funds make low-maintenance investments. You don't need to worry about a manager changing his/her strategy: Because index funds rigorously track specific indexes, the manager doesn't have much say in the matter. Don't fear that your manager will leave for greener pastures, either: Index-fund managers aren't actively selecting stocks, so it doesn't matter much who is calling the shots. Finally, asset growth isn't an issue: Because indexing is a relatively low-turnover approach, index funds don't suffer under the weight of too many assets.
Choosing an index fund isn't such a snap, though. More than 250 index funds ply their trade in more than 45 different investment categories. To complicate matters, some investment categories (such as large-blend) have multiple index funds, many of them locked to a different benchmark. It's getting so you can't tell the players without a program.
To simplify the process of choosing an index fund that meets your needs, consider the following suggestions.Know Which Index the Fund Follows
Vanguard FTSE Social Index VFTSX and Vanguard Growth Index VIGRX both land in the large-cap growth category, and they are both index funds. But their performance patterns have diverged over the past five years through April 2011. What gives? The funds may be large-growth, but they track different indexes.
FTSE Social Index tracks the FTSE4Good U.S. Select Index, which excludes alcoholic-beverage and tobacco makers, as well as firms with unfair or unsafe labor practices and poor environmental records. (We'll cover socially responsible investing in an upcoming lesson.) The index's strict inclusion criteria mean that certain industries and sectors are more represented than others. This leads the fund to a pronounced sector profile, including a much larger stake in financials--the fund holds more than 25% in the sector--versus the Growth Index, which holds just 6% in financials. The financial-services sector has been the worst performing sector over the last five years, acting as a major headwind against the Social Index Fund.
Knowing what index a fund tracks gives you a handle on the risks and returns you can expect and how they differ from other index funds. Although both funds feature Apple AAPL as their top holding (as of March 2011), J.P. Morgan shows up as the second-largest stake in the Social Index, at 3.5%. Wells Fargo is also in the top five holdings. Neither name shows up in the Growth Index at all.Know Your Options
Thanks to the variety of index funds, you have much more flexibility than a decade ago, when tracking the S&P 500 was one of the only indexing options. Today, you can build a well-balanced portfolio made up entirely of index funds.
Here are some common indexes; there are various funds tracking these indexes, or some variation on them.
One of the most common myths about indexing is that all index funds are tax-efficient. Funds that buy the biggest stocks, such as Vanguard 500, do boast terrific tax efficiency: As of April 2011, Vanguard 500's shareholders had kept about 87% of their pretax earnings from the past 10 years. That's because stocks that drop out of the large-cap S&P 500 usually are pretty small players in the index (most companies drop out of the index precisely because they've become too small)—after the 228th stock, none accounts for more than 0.10% of the index. When index funds sell these smaller positions, they don't reap sizable taxable gains.
Don't expect similar tax efficiency from funds tracking other indexes, though. Funds following smaller-cap indexes have to sell stocks that have grown too large to remain in the small-company index; because those are also the funds' largest positions, selling them means realizing large capital gains, which then have to be distributed to shareholders.
You can find out how tax efficient an index fund is by checking out its Fund Report on Morningstar.com.Know the Costs
Another common assumption about indexing is that all index funds are cheap. Because they don't demand the resources of active management, they certainly ought to be. But some index funds charge surprisingly high annual expenses. Consider this: Transamerica Partners Stock Index DSKIX, one of the priciest no-load S&P 500 index funds in May 2011, takes a 0.65% bite out of your investment every year. That is awfully steep when you consider that the Schwab S&P 500 Index SWPPX charges a modest 0.09% fee.
Of course, you might willingly pay more for some index funds, such as Vanguard FTSE Social Index (0.29%), because you want the socially responsible screens it applies in deciding which companies to include in its index. But all things being equal, cheaper is better.
|1||Which is an advantage of index funds?|
|a.||There aren't many of them, so it's easy to choose one.|
|b.||They're low maintenance.|
|c.||They're all incredibly tax efficient.|
|2||Which statement is true?|
|a.||All index funds in the large-blend category follow the S&P 500.|
|b.||All index funds in the large-cap blend category are cheap.|
|c.||Index funds in the large-cap blend category can follow different indexes.|
|3||Which type of index fund is likely to be the least tax friendly?|
|a.||Small-company index funds.|
|b.||Large-company index funds.|
|c.||S&P 500 index funds.|
|4||Which statement is false?|
|a.||You can build a portfolio entirely of index funds.|
|b.||Because index funds don't involve managers actively choosing stocks, their management fees should be low.|
|c.||Index funds are all cheap.|
|5||The Russell 2000 index includes:|
|a.||Large U.S. stocks.|
|b.||Small U.S. stocks.|
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