Lead article: Stock Index Funds

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.


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