If you're counting on long-term healthy returns to lead you to a secure retirement, indexing may be the route for you. Here are the basic pros and cons -- and a tutorial for doing it right.
First, there's an often-overlooked truism that individual investors should keep in mind: You don't have to be a stock picking wizard to profit from the markets. Studies show that the majority of mutual funds don't really deliver above-average returns over the long haul. And trying to predict where stocks are heading often dampens portfolio performance (and ruins your peace of mind).
A better bet for average investors: index funds and exchange-traded funds (ETFs). These types of investments passively reflect the performance of a certain index, such as the Standard & Poor's 500 or the Dow Jones Industrial Average.
An ETF is an investment fund that's traded on stock exchanges, like actual stocks. An ETF can hold basic investment assets such as stocks, commodities or bonds, and it trades over the course of the trading day at the same price (or in a very small range) as the net asset value of its underlying assets. Most ETFs track an index, so the trick is picking the index that's right for you.
When all is said and done, the vast bulk of actively managed mutual funds, including the angels of the financial press that tend to get gushing coverage, don't even reach the average gains or losses of their particular sector, known as their "benchmark." It's a dirty secret that no one likes to talk about.
Indeed, it's even worse than that. Most of them don't profit as much as their peer group as a whole; similarly, most of them tend to lose more than their peers in a down market. More and more investors are getting hip to these facts. Consequently, index funds and ETFs are growing in popularity.
The Biggest Benefit of These Funds...
They're cheap! Index funds and ETFs are inexpensive -- and for good reason. These two types of securities don’t incur the fees and commissions associated with more active trading.
Index funds and ETFs charge annual fees that are only a small fraction of what an actively traded fund charges, because the latter need highly paid "talent" to conduct research and conceive strategy.
After annual mutual fund expenses and trading costs are subtracted from the pure return of the market, the investor profits less than the market average. Index funds and ETFs don't drag down your portfolio through overhead costs.
Index funds and ETFs also involve less stress, but remember: they don't protect you from the market's inevitable ups and downs. But therein lies the point: these vehicles equal the average, so you never have to worry about trying to beat or fall behind the average. You're just along for the ride, comfortable with the knowledge that, despite the claims of most stock pickers, no one can really fathom the future of the market.
Sure, it's possible to beat the market averages, but doing so takes time, expense and expertise. Many fund managers manage to beat the averages, and they won't hesitate to tell you so. But the majority of them do not. Even those managers who were golden boys in the past don't necessarily continue their winning ways in the future. On Wall Street, today's hero is tomorrow's goat.
Many research studies show that, year after year, the average investor earns less than the market averages. With an index fund or ETF, you're not tempted to shift your funds from a loser to a perceived winner. You're freed of any frantic efforts to buy low and sell high. Compulsion and emotion are taken out of the equation.
When you factor in all of the inevitable booms and busts, and the various calamities that can befall your portfolio, earning an average market return is pretty darn good. Rather than depending on self-proclaimed stock picking geniuses, you're relying on the intrinsic genius of the market itself. The market's tendency is to rise at a rate that outstrips inflation, a quality that all long-term investors covet.
Buying A Piece of the Pie -- Getting Started
There are more than 20,000 actively managed mutual funds out there for you to sort through. However, with index funds and ETFs, your choice is considerably narrowed down and made much easier. In one fell swoop, they provide you with diversification, by casting a wide net over a particular basket of related stocks.
ETFs are sold on the stock exchange. You can buy ETFs from a full-service or discount broker. Most ETFs are index funds that hold securities and attempt to mirror the performance of a certain stock market index. Similarly, an index fund attempts to track the performance of an index by holding either the entire contents of the chosen index or a representative basket of the securities in that index.
Your first decision: which index do you want to mirror? Start by considering the broadest, biggest and most widely followed benchmark indexes. Here are the "Standard Seven" on which you should focus:
The Standard & Poor's 500 Stock Index (the S&P 500) is often cited by the press to demonstrate how all stocks perform for the day. The stocks included in the S&P 500 are those of large publicly held companies that trade on the largest American stock exchanges. It's considered a bellwether for the U.S. economy.
The Dow Jones Industrial Average measures 30 large, publicly owned companies based in the U.S. As with the S&P 500, the Dow is considered a proxy for the performance of American business and a leading indicator for economic activity.
The Wilshire 5000 Index is made up of almost all U.S stocks traded on major exchanges.
The Russell 2000 Index selects the smallest 2,000 of the 3,000 largest U.S. companies commonly traded, which makes it a benchmark for small-compay (a.k.a. small capitalization or small-cal) index funds.
The Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE) is a gigantic value-weighted index composed of 21 country indexes that represents most developed country stock markets overseas. It excludes the U.S. and Canada. The MSCI EAFE is the most common and widely followed benchmark for foreign stock funds.
MSCI Emerging Markets Index is a way to capitalize on fast-growing overseas markets. This index entails more risk, but also the opportunity for higher return. This index is dominated by Asia, Latin America, Africa, the Middle East, and smaller up-and-coming European countries.
The Barclays Capital Aggregate Bond Index, formerly called the "Lehman Brothers Aggregate Bond Index," is maintained by Barclays Capital, which took it over from the now defunct Lehman Brothers. This index represents investment grade bonds traded in U.S. The index includes U.S. Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds, and certain foreign bonds traded in the U.S.
An ETF or an Index Fund: Which Is Best for You?
The choice between these two similar investments boils down to their costs, i.e.: management fees, shareholder transaction costs, taxation, etc. Before choosing one or the other, look at the fine print and determine what your accumulated costs will be. Both types of investments have advantages and disadvantages in that regard, depending on the specific vehicle.
Typically, index funds are cheaper, because they don’t use a portfolio manager. They're unmanaged funds that change their individual holdings only when the underlying index changes. Unlike an index fund, ETFs trade on exchanges in the same manner as a stock. That means ETFs provide more flexibility than index funds. However, index funds don't incur commissions and have lower internal expense ratios.
A major advantage of an ETF, compared to an index fund, is its stock-like features. Because ETFs trade on the market, you can execute with an ETF the same types of trades that you can with a stock (unlike an index fund). For example, you can sell short or impose a stop-loss order. In this sense, it's less passive than an index fund.
That said, if you're trying to put away money on a regular basis for retirement, and you want to tie the money to a diversified index-fund portfolio, ETFs cost more over the long haul. With every ETF trade, you must pony up a brokerage commission and you lose a little to the bid-ask spread (the minor difference between an ETF's selling share price and its higher purchase price). If you want to keep matters as cheap and easy as possible, go the index fund route.
A caveat: Watch out for ETFs and index funds that are fiddled with. You can further narrow down your options and make your choice easier, by weeding out those many classes of funds that are not, in the strictest sense, unadulterated index funds. These "enhanced" index funds are designed to beat the underlying index and as such, they're just another manifestation of active stock picking.
When looking at time periods that are measured in decades, stocks on average tend to perform very well -- indeed, they beat all other forms of investment. Index funds and ETFs allow you to exploit this historical truth, by simply going up or down with the market. This "autopilot" approach is perfect for investors who believe in stocks, but who aren't blessed with any stock picking skills -- or are wary of those who claim to have such skills.