Know the Basics of Index Fund Investing

It's often said that human beings havean uncanny ability to make simplethings complex. That certainly seemsto be the case when we look at thejungle of index funds. Can you really benefitfrom carefully choosing from this jungle,or is this proliferation of index fundsanother ploy by the financial servicesindustry to confuse and entice you?

You may still be able to do reasonablywell over the long run by investing in justone or two index funds if you get luckyand have the discipline and patience tostick with the funds—very few people do.Most likely, you'll do much better byinvesting in a well-designed portfolio of 10or so index funds. Allow me to explainwhy, and what you need to know.

The first index fund, the VanguardS&P 500 Index fund, was introduced in1976. As it did when it was first introduced,the fund holds stocks of essentiallythe 500 largest US companies in proportionto their market values. Naturally, theactual companies in the Vanguard S&P500 have changed over the years becauseof mergers and bankruptcies.

When you buy this or any other S&P500 Index fund, a lot more of your moneygets invested in giant companies likeMicrosoft and General Electric, and muchless of your money gets allocated to thesmaller companies within the index. Ofcourse, nothing gets invested in theremaining few thousand smaller US companiesor any foreign companies.

Another problem is that the S&P 500is now dominated by growth stocks.Although the words "growth stock"and"value stock"are constantly bandiedaround, there is no precise and accepteddefinition for the terms. Roughly speaking,growth stocks refer to those stocks inwhich people invest to achieve above-averagefuture earnings growth; investors hopethat such growth will translate into above-averagereturns on the stocks.

This sounds reasonable, but researchshows that investors, with constantcheerleading from Wall Street, almostalways overestimate such future growthand pay too much for the stocks. Simplyput, growth stocks are generally overpriced.Thus, they provide poorer returnsover time than value stocks andsuffer more in market downturns.

So if you put a good part of yourmoney in an S&P 500 Index fund, you'llprobably take too much risk and miss betterreturns from value stocks and evensmall stocks. This was a problem for someinvestors during the last bubble burst.

You can partially rectify the problemby investing in the Total Stock MarketIndex fund, which includes all US stocks,not just the largest 500. But since this isalso market value weighted, you'll still beinvesting mostly in large cap stocks.

The proliferation of index funds hasoccurred to address the shortcomings I justexplained. Today, there are large cap, midcap, small cap, sector, foreign regional, andcountry-specific index funds. There arealso index funds based on different indexesthat are designed to capture the samesegments of the market, but are constructeddifferently. In addition to the differentfunds, the funds now come in two structures:traditional open-end and exchangetraded funds (ETFs). As with most investments,each structure has its advantagesand disadvantages. An investor will needto consider both the advantages and disadvantagesbefore they decide which structuresuits their needs best.

You can create a better diversifiedinvestment portfolio with better risk-returncharacteristics by properly mixingand matching the right index funds fromthe crowded jungle. But before you cancreate the right balance of index funds inyour portfolio, you'll need to acquire thenecessary knowledge or ask your financialadvisor for assistance.

Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2001) and Financial Modeling Using Excel and VBA (John Wiley; 2004), currently

teaches finance at the Fordham University Graduate School of Business

and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.