Index Mutual Funds

Index funds have become very popular in recent years. These funds provide a way for many individuals to invest in the stocks, bonds, and/or other securities that make up widely followed market indexes.

Objectives of Index Funds: Indexing is an investment approach where a mutual fund portfolio is created that mirrors a specific (usually large) group of securities. An index fund invests in the securities (for example, large company stocks, small company stocks, international stocks, bonds, futures) that comprise a particular market measurement (market index). The return on an index fund, therefore, will closely match the performance of the related market index. The most common index funds track the following stock market indexes.

Index	Underlying Investments
Standard & Poor's (S&P) 500	Large company ("blue chip") stocks represent about two-thirds of the capitalized value of the U.S. stock market.
Wilshire 5000	Essentially all stocks traded in the U.S. stock market.
Wilshire 4500	All publicly traded U.S. stocks less the S&P 500; this represents approximately one-third of the capitalized value of the U.S. stock market.
Russell 2000	Small company stocks traded in the U.S. stock market.
EAFE (Europe, Australia and Far East)	International stocks.

Bond index funds invest in particular types of bonds (for example, U.S. Treasury, corporate, U.S. government agency) that comprise various bond indexes.

Managing the Fund: Index funds are considered passively managed -- investment objectives and selections are limited to the index that is being tracked. By definition, index funds maintain investment consistency. Other types of mutual funds (for example, equity funds) are actively managed -- the fund’s manager can change investment selections, objectives, and/or strategies.

Fund Costs: Index funds generally have lower costs than actively managed funds. Administrative, management, and sales fees associated with index funds tend to be less as a result of the passive management of fund assets. Additionally, the extent of research required to manage an index fund is not as great as that required by an actively managed fund.

Tax Considerations: An index fund’s concentration on specific securities, and the long-term nature of the investments, result in a relatively small number of sales of the fund’s holdings (that is, index funds usually have a low turnover rate). Individual tax returns of mutual fund shareholders must reflect their proportionate share of any capital gains the fund recognized during the year. Because of the low turnover rate, there will generally be few capital gains for index fund shareholders to recognize each year.

Investors in index funds (or any mutual fund) should be aware of dividend declaration dates and capital gain distribution dates. If a purchase of fund shares is made just prior to a dividend date, or just before a capital gains distribution date, the investor will be subject to taxes on the dividend/distribution.

Understanding Risks: Index funds do not alleviate market risk -- the possibility that stocks and bonds will decline in value. If the market that a particular index fund is tracking declines, the value of the shares of the index fund will decline.

Many index funds have achieved excellent returns as a result of the strong overall performance of the U.S. market in recent years. When the U.S. stock market experiences a correction or decline, stock index funds may not perform as well as actively managed equity funds, because stock index funds are fully invested in equity securities at all times. During market declines, actively managed equity mutual funds may have a larger percentage of their assets in cash and investments other than stocks.

Investment risk is reduced through the diversification achieved by investing in mutual funds (index or actively managed funds). Most mutual funds hold securities of many different companies; therefore, the risk that an individual security loss will negatively impact the overall return of a mutual fund is reduced.

Performance: Past performance is no guarantee of future success. Index fund investing works best when the stock market operates efficiently. An efficient market is a market where information about all securities is widely known.

Index funds have not performed as well as other types of mutual funds when the market operates in an inefficient manner. An inefficient market is a market where information about all securities is not universally known. In such markets, actively managed funds can take better advantage of the information disparity. Markets that specialize in small companies, and international stock markets, are often considered less efficient markets.

As with any investment, the appropriateness of an index fund will depend on a number of factors, including the investor’s tolerance for risk, financial/investment objectives and goals, and the time frame for achieving financial goals. A Deloitte & Touche financial counselor can provide additional information, and should be consulted before any action is taken.

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	Index Funds: How Do They Work? Personal Finance Advisor by Deloitte & Touche OnLine May 5, 1997