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Indexing Basics: Your Questions Answered

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What is indexing?
Indexing is an investment strategy to match the average performance of a market or group of stocks. Usually this is accomplished by buying a small amount of each stock in a market. An index, such as the S&P 500, is the number that represents the market or group of stocks.

Why index?
Numerous independent studies have shown that indexing provides greater returns over time with less risk and lower taxes. In any given year most active funds underperform markets they set out to beat, especially after fees are subtracted.

What is an index fund?
An index fund is a mutual fund that mirrors as closely as possible the performance of a stock market index. For example, many mutual fund companies have since established S&P 500 index funds to mirror that index by purchasing all 500 stocks in the same percentages as the index.

How do index funds differ from other mutual funds?
1) Index funds track markets closely instead of trying to outperform them
2) Index funds tend to be much cheaper since there are no highly paid managers to pick stocks
3) Index funds delay capital gains taxes because stock turnover (buying and selling) is low.

How does indexing work?
For the average investor, indexing involves:
1) Picking indexes that provide the right mix of return and risk for their situation
2) Picking funds that follow those indexes.

Why don't index investors try to beat the market?
Index investors are content with the average performance of a market. They are skeptical that a money manager can improve on the average performance without raising risk. They are even more skeptical after hefty fees are subtracted.

What is an Exchange-Traded Fund (ETF)?
An exchange-traded fund is an index fund which is traded on the stock market. Some common ETFs are the Nasdaq-100 Index Tracking Stock (QQQ), which tracks the Nasdaq-100 and Standard & Poor's Depositary Receipts (SPY), which tracks the S & P 500.

What can an index fund track?
Theoretically, an index can be created to track any publicly tradable asset worthy of investment. Index funds exist for a broad range of asset classes, including short, intermediate, and long-term bonds; U.S. large and small company stocks; value (low price relative to earnings) and growth (high price relative to earnings) stocks; international large and small company stocks; emerging market stocks, and others. In practice, most index investing involves common stocks and a majority of that centers around the S&P 500 Index.

How do index funds provide higher average returns?
Lower management fees make this a near mathematical certainty that a fund tracking an index will outperform actively managed investors seeking to beat that index. Why? By definition the average performance of investors in a certain type of asset is equal to the index of that asset type, before fees. So:

Average active investment return before fees = Index fund return before fees

Then fees are considered. Index funds almost always have lower fees than stockpicking funds, usually by 1% to 2% per year. So the equation is:

Index fund after fees = Average active investment return (1% to 2%)

It turns out that the average index funds outperforms stockpicking funds which target the same markets by about the same amount as the difference in fees, year in and year out.

Why do index funds have lower fees?
Index funds can be managed by a small staff. A personal computer can calculate at minimal expense how much to buy or sell of each stock when money flows in or out of an index fund. There is no need to pay a "star" manager with a strong track record to choose winning stocks. And typically index funds spends far less money on advertising to promote their record than firms with "star" managers.

How do index funds offer lower risk with diversification?
Indexing guarantees that an investor's money will be spread over the entire market. Mutual funds or individual investors who pick stocks generally restrict themselves to a limited number of stocks so they can devote sufficient time to each.

What tax advantages do index funds deliver?
Capital gains taxes are delayed because the index mutual fund buys and holds stocks longer than active funds that buy and sell stocks in hopes of outperforming the market. A stock is sold by the index fund only made if a company is removed from an index or investors request their money back. Because money that would have been paid out as taxes can keep producing investment returns, the effect of delaying taxes is powerful over time.

How do index funds offer less supervision and worry?
Since operating an index mutual fund involves no decision making, there is little for an investor to supervise. Indexing eliminates the risks, costs, and uncertainties of "active" management (stock picking and market timing). Index investors tend to sleep easier at night.

What differences are there between index funds?
Funds may track very different indexes. Some indexes (eg, the S&P 500) are set up to measure the performance of large companies. Other indexes focus on small companies (the Russell 2000 being one of the most famous small-cap indexes), international stocks (MSCI-EAFE), and bonds (Lehman-Brothers Aggregate Bond). In addition, some indexes incur smaller fees. In some cases minor differences can occur from different trading costs in efforts to buy or sell stocks for indexing purposes.

What percentage of mutual funds are beaten by index funds?
Over the long term the S&P 500 index has beaten about 65-80% of mutual funds, depending on the time period. This is especially true when one takes into account "survivorship" bias. This bias occurs because the worst performing funds typically go out of business and are not counted in long-term records. Thus long-term performance of surviving funds to be higher than the sum of annual performances. Many fund groups "seed" numerous funds with small amounts of money precisely in order to weed out poor performers and to promote the "star" funds.