Index Mutual Funds

The other day one of my friends was asking me about investing in mutual funds.  He wanted to know if I knew of any good fixed income mutual funds that I could recommend for him.  So, I asked him if he prefers a “passive” or “active” approach to mutual funds.  He asked me what I was talking about.  Then, I realized how often I take for granted what seems like common investment terms to me probably sound like a complete foreign language or nonsense to others.

This is probably true in most professions, isn’t it?  Someone carries on a conversation about their chosen profession with us.   Then, they start using professional specific jargon as if we know what they are talking about.  And while our head is nodding yes, our mind is spinning around trying to make any sense of the gibberish.

I know this is true of myself and other personal finance writers who try to teach the basics of investing.  When you want to learn how to start investing, it is important to have a general idea of how to invest in index mutual funds.  This is also referred to as a “passive approach.”  I know more gibberish.  Don’t worry, I will speak in English and try to explain the basics of index mutual funds as an investment strategy.

What Are Index Funds?

In the most basic sense, index funds are a group of stocks or bonds that consist of holdings (stocks and bonds) listed on a particular index.  For example, the S&P 500 Index represents the 500 largest publicly traded companies in the United States.  These companies are considered “large cap” stocks.  The S&P 500 is considered the bellwether for the U.S. economy.

So, if you wanted to own stocks that represent the majority of the U.S. GDP, an S&P 500 index mutual fund would be a good place to start. The returns of this mutual fund would mirror the returns of the S&P 500 index, (minus fees).  The S&P 500 is probably the most popular index followed by investors as it represents the world’s largest economy.  What about fixed income or bonds?

What if you wanted to invest in a bond index fund that was as broad as the S&P 500?  The Barclay’s Aggregate Bond Index (formerly called the Lehman Brothers Aggregate Bond Index) is a broad based bond index.  The index consists of mainly investment grade bonds in the following areas:  U.S. Treasury, Municipal, Government Agency, Mortgage Backed and Corporate Bonds.

The Basic Concept of Index Mutual Funds

Index mutual fund investing is often called passive investing.  What does that mean?  Whenever you invest in an index fund, you are not trying to outperform the underlying index. You simply want to  match the returns of the particular index.  Hence, it’s passive approach.  This is considered to be more popular among buy and hold investors who plan to hold their mutual funds and make little changes to their funds over time.

Index Mutual Fund Examples

A bond index mutual fund would simply replicate the performance of the underlying index.  Here is an example of 2 index mutual funds that represent the indices we have spoken about so far:

S&P 500 Index – Vanguard 500 Index – Mutual Fund Ticker Symbol,  VFINX

Barclay’s Aggregate Bond Index – Vanguard Total Bond Market Index, VBMFX

You may be wondering why I used a Vanguard fund for each of my examples.  Well, its no secret that Vanguard is known as the standard when it comes to low-cost index mutual funds.  For the record, there are plenty of other good index funds out there as well.

There are as many types of index mutual funds as there are indices.  For example, there are index funds that mirror all types of stocks and bonds including foreign and domestic holdings.   You may have even heard of a few of these indices: Russell 2000,  FTSE All World Index, MCSI Mid Cap Index.  Don’t worry about what these terms mean.  The significance is that they are identifiers of particular types of indices and funds that are available to you as an investor.

Example of an Index Mutual Fund Portfolio (hypothetical)

If I was trying to build an all index portfolio of mutual funds, the asset allocation might look something like this:

50% Vanguard S&P 500 Index Fund

20% Vanguard Total Bond Index

30% Vanguard Total International Stock Index

Advantages of Index Mutual Funds

Low Cost

Simplicity

Tax Efficiency -due to lower turnover versus active funds (thanks for reminding me Kevin!)

Little Style Drift – meaning the underlying fund maintains it’s stated objective

Disadvantages of Index Mutual Funds

No upside performance to target index

Potential laziness on investors part

So, where do you go from here?  The first thing is to determine whether you prefer this passive and less time consuming to investing over a more “active” approach, which I will cover in my next post.  The most important thing to remember is that you need to educate yourself on these general concepts.  No one is going to care as much about your investments than you.

Related posts:

1. 4 Ways to Cut Investment Costs
2. Fixed Income Funds
3. 5 Investment Tips That Will Make You a More Successful Investor