Chapter 4: The Answer Is Index Funds

Chapter 4: The Answer Is Index Funds

Do you find the glut of investment information so overwhelming that you don't know where to begin to put your money? Do you want to "be in the market," but have no time to research stocks or mutual funds? Do you cringe at shelling out high brokerage charges and commissions? Do you have no desire to be a financial wizard, but have enough smarts to know that an IRA with stocks will probably do better over time than just about any other IRA?

Then you should consider buying index funds.

What Makes an Index Fund Different?

An index fund invests in stocks or bonds that match or reflect one of the many market indices, making its performance very similar to the performance of the index it matches or reflects. For example, an S&P 500 index fund has a portfolio consisting of the stocks that make up the Standard & Poor's 500 Composite Stock Price Index. A Wilshire 5000 index fund reflects all of the stocks in the U.S. market, and a Wilshire 4500 index fund reflects all of the stocks in the U.S. market except the S&P 500.

As a general rule, an S&P 500 index fund outperforms most managed funds over time. Face it, fund managers have good years and bad years because they choose stocks for their portfolios. Very few fund managers are skilled enough to outpace the market over time. So, as an investment, buying an index fund should be done with a long-term view strategy -- particularly an advantage for your retirement account.

For example, one highly rated actively managed fund is the Dodge & Cox Stock Fund (DODGX). Over time it has performed well. At the end of January 2000, its five- and ten-year returns were 19.88 percent and 15.52 percent, respectively. The Vanguard Index Trust 500 Portfolio (VFINX), on the other hand, returned 26.52 percent and 18.28 percent in the same comparative time spans.

The Index Fund Advantage

Low fees: Because index funds aren't actively managed, they generally can offer lower management fees and their operating fees are lower, too. Fewer fees enhance your returns. For example, the annual expense ratio for the Dodge & Cox Stock fund (DODGX) is .56 percent. For the Vanguard Index Trust 500 Portfolio (VFINX) it's just .18 percent.

Tax Advantages: Inherent in an index fund are some tax advantages that also help boost the fund's return. An index fund doesn't turn over its portfolio nearly as frequently as a managed fund, so it doesn't generally realize the capital gains. Strong Growth fund (DODGX) averages a whopping 145.4 percent turnover, and the T Rowe Price Equity Index 500 (PREIX) fund averages only 6.4 percent.

Market Alignment: By their nature, index funds are fully invested in stocks. Most other funds keep some cash reserves. When the market makes a big move, an index fund realizes every penny of upward movement, while the managed funds don't. On the other hand, when the market falls, the drop isn't nearly as extreme with a fund run by an astute manager.