Index Mutual Fund Tips

An index fund is a type of mutual fund that is designed to specifically track an index.

So, let's unpack that statement:

A mutual fund is basically a pool of money that invests in stocks and other instruments. Investors give money to the mutual fund managers to invest for them, and in exchange get shares. These shares rise and fall in value based on the movement of the mutual fund's investments. A mutual fund's price (called "NAV," for "net asset value") is updated once every business day after the stock exchanges close. Learn more about mutual fund basics at Investopedia. www.investopedia.com/university/mutualfunds/

You've heard of the Dow Jones Industrial Average, the S&P 500, the Nasdaq, maybe even international stock exchanges like the CAC-40, the FTSE (pronounced "footsie") or the DAX. These are all indexes. A stock index tracks the movement of a certain basket of equities. For example, the Dow tracks the performance of the top 30 blue-chip (big, stable) companies in the USA. The S&P tracks the performance of the US's largest 500 publicly-traded companies.

What you probably didn't know is that there are lots more stock exchanges than the evening news reports. Nearly every nation with a free market has at least one stock exchange, and some have several. In the United States, there are many indices including the ones listed above.

In addition, there are indexes that track specific sectors like real estate, healthcare, commodities (raw materials like gold, oil, corn and wheat) and energy companies. There are indexes that track stocks based on size, like the S&P 500 and the Russell 2000 (the top 2000 largest companies in the USA).

An index mutual fund is designed specifically to track the performance of a chosen index. That's it.

Here's how index funds are different from traditional mutual funds: traditional mutual funds are "actively managed." That means that managers actively make decisions about how to invest the money the mutual fund has. These managers seek to beat the average market returns. Sometimes these managers manage to do so. More often, active managers actually underperform the overall stock market. Whether the manager outperforms or underperforms the overall market, the mutual fund charges fees. These fees deduct from an investor's returns.

Index funds are not actively managed. They don't try to beat the market. Some don't even have human managers -- all trades are executed based on computer programs. The point of a mutual fund is to capture average market returns.

All mutual funds have associated fees. Some also have something called a "load" which is a fee that's either charged up front, when you buy, or at the back, when you sell shares. These are called "front load" and "back load" respectively.

Mutual fund fees range from 0.20% to about 8%. Loads range from 1%-6%.

Fees and loads are absolutely critical when evaluating a mutual fund. The higher the fees and loads you pay, the less profit you will make. In fact you'll even pay fees and loads when your investments lose value -- a painful double-whammy.

You should never pay a load on any mutual fund if you can possibly avoid it. The only circumstance in which you should pay a load is if your 401(k) or 403(b) plan only offers load funds -- and there are tax advantages to making these investments. Never pay a load if you can possibly help it.

The good folks at FundAdvice.com have put together a list of dozens of load funds and their no-load equivalents.

The publicly-traded company Morningstar has created a business based on rating mutual funds. Actively-managed and index mutual funds are rated based on their performance compared to their peers. Funds are awarded a rank between 1-5 stars, 5 stars indicating a top performer.

The problem with Morningstar ratings is that they change. Top funds rise and fall every year. If an investor tries to stay invested in only 5-star funds, she will incur tax liabilities and lost days in the market as money is moved around.

Another issue with Morningstar ratings is that they can be misleading. Is a 5-star fund better or worse than a 3-star fund? What about a 3-star fund that's stayed at 3 stars for years, versus a 5-star fund that's new? How do fees and loads play into the Morningstar ratings?

The short answer is, Morningstar ratings should be ignored. Morningstar.com is a fantastic resource for researching fund portfolios, historical performance and holdings -- but that is all. The Morningstar rating system is no better or worse than anyone else's rating system.

Passive investing is the technique of investing in only index funds. By investing regularly and rebalancing periodically, a savvy investor can handily beat the average market return -- and even limit risk! -- without trying very hard.

Passive investing depends completely on proper asset allocation, low fees, and discipline. Passive investing sounds wimpy, but it's certainly not for the faint of heart! In addition, passive investors must choose to take responsibility for their own investments. Passive investors realize that no fund manager is going to produce consistent above-market returns.

Passive investing, and the construction of "Lazy Portfolios," is the subject of another lens. Rest assured that it is possible, even easy, to create a portfolio of just a few mutual funds that will consistently beat the returns of the market while reducing risk. Check out the MarketWatch assortment of lazy portfolios for more details.

Four companies are head and shoulders above the rest for providing index funds. Here they are, in alphabetical order.

Dimensional Fund Advisors
Dimensional Fund Advisors are the top-level provider of incredibly diverse mutual funds. Unfortunately, DFA funds are only available to institutional investors, like pensions or investment advisors. DFA funds are much more diversified than their competitors. Unfortunately they aren't available to the average investor.

If you have access to Dimensional funds, by all means use it. Otherwise T. Rowe Price or Vanguard funds are recommended.

Fidelity

Fidelity is a leading provider of high-fee, high-load actively-managed mutual funds. Unfortunately the vast majority of the funds Fidelity offers are the antithesis of smart, savvy index fund investments.

Fortunately, market pressures have forced Fidelity to create a handful of extremely low-cost index funds. The Fidelity Spartan funds compete directly with their Vanguard counterparts and even have lower expense ratios. Fidelity is not recommended due to their abusive business practices and excessive fees. However, some investors may choose to take advantage of the few Spartan funds Fidelity offers.

T. Rowe Price

T. Rowe Price is an established, publicly-traded company. They offer dozens of no-load funds with expense ratios well below the industry average. The best thing about T. Rowe Price is that they will let a beginning investor actually start a new mutual fund account with $0, so long as the investor agrees to a regular monthly purchase of $50 or more. This alone makes T. Rowe Price an outstanding choice for the beginning investor.

Vanguard

Vanguard invented the index fund as an industry and is still by far the world leader in index funds. In addition, Vanguard funds overall have the lowest expense rates. Most Vanguard funds have an initial minimum investment of $3000, which is out of reach of the typical beginning investor. If you can afford it, Vanguard's funds are the way to go. If not, go with T. Rowe Price.

Bogleheads.org
A very active forum dedicated to the Boglehead philosophy of index investing. Friendly to newcomers. A great place to ask for advice on constructing an index fund portfolio.

Morningstar Forums
A vast forum site with subsections devoted specifically to Vanguard funds and mutual fund investing.

Merriman
A Seattle-based investment advisor that produces a podcast devoted to index investing and their own model lazy portfolios. Their services are available to investors with a minimum portfolio value of $200,000.

Portfolio Solutions
A fee-based investment advisor that charges 0.25% per year (minimum $2000) to manage your portfolio with a lazy-portfolio-based approach. Rick Ferri, a respected and active member of the Bogleheads.org forum, is CEO.