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When Index Funds Are Right for You

By Mark Biller
Sound Mind Investing

CBN.comA fundamental decision every stock investor makes, whether realized or not, is whether to attempt to beat the market or to be content to merely match the market.

To beat the market, you must use actively-managed funds; that is, funds that frequently trade stocks in an effort to hold only those that will do particularly well.

To merely match the market's returns, you use passively-managed "index" funds that make no attempt to discern how specific stocks will perform, opting instead to buy the entire group of stocks that make up an index like the S&P 500. In doing so, the indexer is willing to accept whatever the market rate of return is—over the long haul, stocks have returned 10%-12% per year.

From 1999 through 2006, SMI's actively-managed Upgrading strategy has trounced the broad market index (Wilshire 5000 Index), with an annual rate of return of 12.6% versus 4.5%. After a stretch like that, some might be tempted to write off using an indexed approach. But that would be a mistake, as index funds can be extremely useful. Let's look at their benefits:

Simplicity. Index funds are great for beginners because they're very low maintenance. You don't have to know anything about picking funds or diversification strategies; just buy a fund like Vanguard's Total Stock Market fund and—presto!—you own a share in the entire U.S. market. And after you make your investment, there are no monitoring or fine-tuning chores for the next 12 months until it's time for your annual rebalancing (to make sure the stock/bond mix in your whole portfolio is what you want it to be).

Predictability. You can buy and hold them for years because their performance is predictable—you'll get what the market gives. While you know you won't outperform the market, you also know you won't lag the market either. That's more than most fund investors can say, since studies have shown that as many as 80% of actively-managed funds fail to outperform the market over time.

Availability. Index funds are usually included as options in most retirement plans. If you're stuck with a half dozen mediocre mutual fund choices in your company 401(k) or other retirement plan, the knowledge that there's a better than 50-50 chance that your specific fund choices will end up trailing the market can make an index fund look very appealing.

When shopping for index funds, it's important you understand that they're not all created equal. In particular, there are two areas where index fund investors can go astray. First, the returns of index funds will vary widely in a given year depending on the targets they attempt to replicate. Only a fund that tracks the entire market (like the Vanguard Total Stock Market Index fund) will give you the "market-matching" returns we've been talking about. So if that's your desire, stick with that fund (or a combination like the S&P 500 fund and the Extended Market fund that, together, essentially cover the entire market). Many index funds track only a particular segment of the market; their returns will reflect that segment and may be more or less than the overall market. So, be sure you understand which index your fund is trying to mimic.

The second area where investors can go astray is to ignore expenses. The returns from index funds will vary depending on the fees and overhead the fund passes on to shareholders. Even among index funds focused on the same target there can be significant differences due to costs.

The best index funds not only closely track their target index, but they keep their costs extremely low. Vanguard's S&P 500 index fund charges just 0.18% per year. Contrast that to the 79 other S&P 500 index funds in Morningstar's database. For instance, the Morgan Stanley S&P 500 fund charges 1.4% annually, with a 5% deferred sales charge. Hang on for five years and they'll mercifully reduce your management fee to "only" 0.64%. Yet this fund invests in the same stocks as the Vanguard 500 fund!

These additional costs really add up. Fifty thousand dollars invested in the Morgan Stanley fund will cost you $700 per year versus just $90 at Vanguard. Surely you can think of a better use for that extra $610 this year. Cumulatively, the investors in the Morgan Stanley S&P 500 fund will overpay by $14.5 million dollars this year. This problem is definitely not just limited to Morgan Stanley. High-cost index funds abound.

Determining if your index funds are good ones isn't difficult. You can simply compare the posted returns of your funds against those of the Vanguard index funds. If your returns are similar over both short and long-term periods, chances are you're invested in a suitable alternative. If, however, you see your fund trails the Vanguard fund by more than .25% per year, it's probably worth investigating a change.

In our Sound Mind Investing newsletter, we try to regularly emphasize why we are here serving you in this way: We want to help you to have more so you can give more to share the good news of Christ's love with the world.

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