Buying an Index Fund

An index fund is, by its very nature, a well diversified portfolio of stocks.  Buying an index fund provides investors with an opportunity to diversify away the risk associated with individual stocks; thereby lowering the overall risk of their investment portfolio.

In this publication, we're going to discuss the topic of index funds.  As part of that discussion, we'll first talk about the different types of index funds found on the market today.  Next, we'll talk about fee structures, and how they can affect the performance of a fund.  Finally, we'll provide a list of some of the better performing index funds.

Stock Market Efficiency

The stock market is a fairly efficient trading place.  There is a great deal of money at stake and market analysts, as well as investors, are constantly reviewing new information.  As the impact of new information is understood, investors buy and sell stocks.  In doing so, the stock market's efficiency remains intact.

Many investors believe in the efficient market theory, and have given up on the idea of picking individual stocks.  Instead, they have turned their attention to the simplicity of index funds.  But there are literally hundreds of index funds to choose from, and the asset classes on which each index is built can be very different.

Types of Index Funds

One way to pick an index fund is to select from a certain asset class, or category, of funds.  For example, the investor can choose from a selection that includes:  large and small companies, growth and value, equity and fixed income, high-yield and investment grade, domestic and international.

An index fund might contain as many as 500 company stocks.  But the vast majority of these companies will have no impact on the return of the fund.  Most index funds are market-cap-weighted, meaning the overall return is generated by a small number of large companies (in terms of market capitalization) held in the portfolio.

The investment outlook will also play a role in determining the type of fund picked.  Mutual funds are better suited to investors that want to purchase shares over an extended period of time.  However, if the intention is to move a large sum of money into an index fund, then an exchange-traded fund may be the better choice.  The investor pays a brokerage fee to buy and sell shares in the exchange-traded fund, but the management fees are usually lower than more traditional open-ended mutual funds.

Index Fund Fees

If an investor purchases shares weekly or monthly, then brokerage fees of exchange-traded funds will likely offset any savings from lower management fees.  If the intention is to purchase the index over time, economics would likely dictate buying an open-ended fund such as an index mutual fund.

This next point may come as a surprise, but not all index funds have low expense ratios.  In fact, there are a large number of funds with expense ratios that are over 2%.  It's difficult to imagine how a management team can justify expenses this high.  An index fund is not considered an active fund.  Funds should have expense ratios that are no higher than 0.5%.

Low Research and Turnover Costs

An index fund doesn't require a great deal of stock research.  The objective of the index fund itself will define a limited set of investments or securities.  Turnover, which is the buying and selling of securities by the fund's management, should also be quite low.  Low turnover means reduced brokerage and trading fees.  Limited research costs and lower trading fees are two more reasons an index fund should be efficient when it comes to fees.

Performance of Index Funds

When deciding which index fund to buy, it's best to consider purchasing funds that are broadly diversified.  While it's possible to find an index of the NASDAQ 100 or the Dow Jones Industrials (30 companies), a fund that tracks a broad index, like the S&P 500 covers a much larger range of equities.

A broad index fund also has an advantage over funds that specialize in a single area, such as small capitalization stocks.  If a company gets too large, then it is removed from the fund.  This creates higher turnover, which brings up another point.

Turnover Hurts Performance

Seek out funds that have low turnover.  This is a critical attribute for an index fund.  High turnover means high trading costs, which eat away at the overall return on the fund in the same way as high expense ratios.  In fact, turnover in an index fund usually costs more than an active fund because an index fund has to make incremental investments in stocks that are too small to purchase efficiently.  This can be devastating to a fund's performance.  A small cap fund with high turnover will typically under perform the index it's tracking by 2 to 3%.

Index Funds versus ETF

A true index fund, just like a mutual fund, is priced at the end of the day.  Exchange traded funds have intra-day pricing, since they are actively traded throughout the day.  While ETFs can have lower expense ratios, brokerage fees can eat into the overall return on investment.

Since the number of shares of an EFT remains constant, the investor doesn't have to worry about redemptions in shares by other shareholders.  These redemptions force the fund to realize a capital gain.  EFTs are not required to distribute a capital gain to shareholders, but mutual funds are required by law to distribute such gains.

Best Index Funds

Now that we've covered the various types of funds and fees, we're going to finish this topic by listing some of the best performing index funds over the last several years.  The criteria used to select these index funds is the three year return on NAV as of May 2011.  All the index funds listed below are exchange traded funds, and are broken down into two categories:  domestic and international index funds.

Best Performing Domestic Index Funds

Best Performing International Index Funds

About the Author - Buying an Index Fund

Bill Sharlow is the Editor of Money-Zine.com.  Copyright © 2004 - 2011 Money-Zine.com