Index Investing

Indexing is an investment approach that seeks to track the performance of a specific benchmark, or index. Index funds do this by holding all (or a sample) of the securities in the index being tracked. This “passive” investment approach emphasizes broad diversification, limited trading of the securities held in the portfolio, and low costs. The emphasis of indexing is on broad areas of the market and not individual securities.

THE BENEFITS OF INDEXING

Diversification

Maintaining a well-diversified portfolio is an essential part of a solid investment plan. Indexing can be an ideal way to achieve diversification. It’s difficult for actively managed funds to compete with index funds when it comes to diversification because index funds generally hold most or all of the securities in their target indexes. An actively managed fund typically holds a much smaller selection of securities that the fund manager believes will outperform its benchmark index. Although the diversification that index funds offer can’t protect you against broad market declines, it can reduce the risk posed by a dramatic decline in any one security or economic area.

Low Costs

Index funds have a return advantage from the beginning compared to actively managed fund and that is much lower costs. There are two main reasons that indexing costs less:

• Lower management fees: It costs less to manage and operate an index fund. That’s because index funds don’t have to employ highly paid fund managers and their staffs to analyze and select stocks.

• Lower transaction costs: Index funds use a fundamental buy-and-hold approach, which means that index fund managers generally turn their portfolios over far less often than active fund managers. This reduces the brokerage, commission, and other expenses associated with trading securities, and results in lower trading costs. You get to keep more of your money when using index funds.

Competitive Performance

Thanks to their diversification and low costs, index funds can be an effective way to achieve competitive returns over the long run. Depending on the asset class, various studies have shown 80% to 90% of index funds beat actively managed mutual funds in a given year.

Potential Tax-Efficiency

As noted earlier, index funds typically have much lower portfolio turnover than actively managed funds. Therefore, most index funds tend to realize and distribute only modest capital gains. This is particularly important if you hold index funds in taxable accounts.

Simplicity

The investments inside of an index fund are transparent and easy to compare. They have a precise, easily understood objective—to track the performance of a specific index. With index funds, you always know how your money is invested.

What are the risks?

As with any investment, it’s important to remember that mutual funds (including index funds) are subject to risk, including possible loss of principal. In addition, diversification does not ensure a profit or protect against a loss in a declining market. Finally, investments in bond funds are subject to interest rate, credit, and inflation risk. That’s why index investors should make a long-term investment commitment.

Common Indexes

Below are common indexes used by Exchange Traded Funds and other investment products.

The Dow Jones Industrial Average: The oldest barometer of the U.S. stock market and the one most often quoted in the media. The Dow tracks the stocks of 30 major companies from a variety of industries.

Standard & Poor’s 500 Index: Synonymous with the “U.S. stock market,” the S&P 500 tracks the stocks of 500 leading U.S. companies.

Dow Jones U.S. Total Stock Market Index: A measure of the entire U.S. stock market, the Dow Jones U.S. Total Stock Market. Index includes large, midsize, and small companies.

Russell 2000 Index: The Russell 2000 represents the smallest two-thirds of the 3,000 largest U.S. companies.

The Nasdaq Composite Index: The Nasdaq Composite Index includes the stocks of more than 3,000 companies listed on the Nasdaq Stock Market, including the stocks of many widely followed technology companies.

Morgan Stanley Capital International Europe, Australasia, Far East Index: Designed to measure developed markets equity performance outside North America, the MSCI EAFE Index tracks more than 1,000 stocks traded on 21 exchanges in Europe, Australasia, and the Far East.

Barclays Capital U.S. Aggregate Bond Index: A measure of the taxable, investment-grade U.S. bond market, including U.S. Treasury and corporate bonds, the Barclays Capital Aggregate Bond Index excludes low-quality bonds whose issuers are considered more likely to default.