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At the height of the stock market boom in 1999, a friend of mine complained
that he didn’t have enough time to do the necessary homework to invest. He
felt that investment opportunities were slipping by while his money was gathering
dust in a money market account. He could have solved (and simplified)
his problem by investing in an index fund or exchange-traded fund.
Discovering index funds
Index funds are sometimes called passively managed funds. Index fund managers
try to closely track the performance of a target market index. Index
funds buy and hold all, or a representative sample, of the securities in a particular
index. The composition of the portfolio of the index fund is determined
by the index it is trying to mirror. For example, a Standard & Poor’s
500 index fund will match the percentage of stocks held in the Standard &
Poor’s 500 index. In contrast, in an actively managed fund, a fund manager
tries to outperform similar funds or an appropriate market benchmark.
Actively managed fund managers use expensive research, market forecasts,
and their own judgment and experience to buy and sell securities. This expertise
makes the operating costs of a managed fund higher than a passively
managed index fund.
The operating costs for passively managed index funds are often 0.20 percent.
In addition to their low cost, the appeal of index funds is twofold. First,
the index fund will match the returns of the index it mirrors. If the market
does well and the value of the index increases, the investor does well. The
second reason investors like index funds is that some indexes better reflect
their individual investing objectives. The downside of index funds is that
investors will never have the opportunity to significantly outperform the
market. For more information about index funds, see the following:
IndexFunds.com (www.indexfunds.com), shown in Figure 6-2, is a helpful
all-purpose online resource for index mutual funds. You’ll find a
beginner’s message center, ten favorite indexes, and useful articles and
links. Use the screener to search for investment candidates using criteria
such as expense ratios, net assets, or five-year returns.
The Index Investor (www.indexinvestor.com) is a useful Web site for
registered members who are seeking better index fund performance
through asset allocation. IndexInvestor.com is divided into free and subscription
resource areas. Subscriptions are $25 per year.
Vanguard (flagship2.vanguard.com/VGApp/hnw/FundsStocks
Overview) features the Vanguard 500 index fund, which has been
around for more than 25 years. You can read all about the benefits
of indexes online.
Becoming aware of exchange-traded funds
Exchange-traded funds are passively managed funds that are traded on stock
exchanges. A share of an exchange-traded fund is a share of a unit investment
trust. Unit investment trusts are formed by investment companies with the
intention of acquiring a portfolio of shares to be passively managed over a
fixed period. The trust is then terminated.
According to The Wall Street Journal, as of September 2004, exchange-traded
funds had combined assets of $180.8 billion, up 20 percent from $151 billion
in December 2003. To create an exchange-traded fund (ETF), investment companies
gather stocks or fixed income securities into one basket and then sell
shares in the trust on a stock exchange. In other words, ETFs trade like
stocks and can’t be abused by market timers.
As of September 2004, there were 143 ETFs. ETFs always include securities
that are included in an index. ETFs come in several different types and are
based on broad market sector indexes and international indexes. The following
are a few examples:
Spiders: Track the Standard & Poor’s Deposit Receipts (SPDR, pronounced
“spider”).
Cubes: Track the NASDAQ 100 of big nonfinancial stocks using the ticker
symbol QQQ — hence the name cubes.
Diamonds: Track the Dow Industrial Average using the ticker symbol
DIA — hence the name diamonds.
Vipers: The Vanguard Group has launched Vanguard Index Participation
Equity Receipts, know as Vipers. Each Viper is a new class of shares of
one of the company’s well-known index funds. The underlying portfolios
are equal, though fees and other features are different from those of the
Vanguard funds.
ETFs are inexpensive to own. Expenses for an ETF are usually 0.4 percent,
compared with 1.4 percent for the average equity mutual fund — but you
have the expense of the broker. If you follow dollar-cost averaging, your brokerage
fees can quickly add up. On the other hand, you don’t have to worry
about a minimum investment. Other advantages of ETFs include
The ability to buy and sell at any time during the trading day
Instant exposure to stock portfolios of your choice: You can select an
ETF that meets your specific investor objectives.
The ability to buy on margin: These purchases are generally subject to
the same terms that apply to common stocks.
No sales load: You still have to pay a brokerage commission.
No high management or sponsor fees
No minimum initial deposits
Potential tax efficiencies: Because ETFs transfer securities between
investors, there are no tax consequences to the fund.
For more information on exchange-traded funds (ETFs), see the following
Web sites:
iShares (www.ishares.com) offers online tools such as the ETF Allocator,
which allows you to create a portfolio of ETFs based on the Dow Jones
U.S. Sector and Total Market Indexes. This company owns the iShares
Russell 2000 Index Fund, which seeks investment results that, before
expenses, generally correspond to the price and yield performance of
the Russell 2000 Index.
Investment Company Institute (www.ici.org/funds/abt/index.html)
is a national association for mutual fund companies that provides
answers to frequently asked questions (FAQs) about exchange-traded
funds. You also find useful industry statistics, investor education, and
industry news.
American Stock Exchange (www.amex.com) offers a market summary of
all ETFs, product information on specific ETFs, new listings of ETFs, an
ETF screen and return calculator, and investor education. Additionally,
you can download information about all of the American Stock Exchange–
traded ETFs and end-of-the-day ETF prices. At the Home Page, click ETFs
in the left margin.
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