Index funds are good way to build a sound portfolio

Many investors see no shame in being average.

That is why more than $548 billion is invested in 287 index mutual funds, according to Lipper Inc. These funds seek to mirror the performance of a given stock or bond index. Nothing more, nothing less.


Building a personal portfolio of index funds can be easy or complicated. You can own two or three broad-based funds, or get fancy, owning up to a dozen that track regions or specific investment styles.

The passive investment strategy began 36 years ago when Wells Fargo launched the first equal-weighted New York Stock Exchange portfolio for the Samsonite pension plan. The Standard & Poor's 500 index led the march of index funds to prominence.


Born 31 years ago, the Vanguard 500 Index has grown to $129 billion in assets and has a three-year annualized return of 9 percent. It requires a $3,000 minimum initial investment and has a low 0.18 percent annual expense ratio.

Another giant, Fidelity Spartan 500 Index Fund, has $18 billion in assets and a 9 percent three-year annualized return. Requiring a $10,000 minimum initial investment, it has an annual expense ratio of 0.10 percent.

"For some investors, average looks darn good," said Jeff Tjornehoj, senior research analyst with Lipper in Denver. "More than a few people have looked back at active management of their stocks and bonds and said, 'Gee, I wasted the past 10 years on all those things people told me were hot.' "

An upside of index funds is that studies indicate over time they outperform 75 percent of active portfolio managers. A downside is that every index fund holds some stocks or bonds even when they're suffering or failing, without the ability to dump them. It also can't increase holdings in up-and-coming stocks.

Index funds hold all the securities in the index, unless the index size or regulatory restrictions preclude that and they must construct a portfolio approximating characteristics of the index.

Two or three basic index funds can provide a solid investment foundation for an individual investor.

"We are a big believer in having the broadest view in terms of diversification," said Fran Kinniry, principal with Vanguard Group's Investment Counseling and Research Group in Wayne, Pa. "With three index funds - a total U.S. equity fund, a total international fund and a total bond fund - you basically own all of the publicly traded companies."

For example, Vanguard Total Stock Market Index Fund Investors Shares has a three-year annualized return of 10 percent; Vanguard Total International Stock Index Fund Investor Shares, 22 percent, and Vanguard Total Bond Market Index Fund Investor Shares, 4.25 percent.


Each ranks in the upper one-third of all managed and index funds for its category, and together they represent about 6,000 stocks and 4,000 bonds.

Investors can add individual stocks or more specialized index funds in areas they consider promising. Some common index choices are blue chips, micro-caps, balanced (stock and bond), value and regions of Europe or Asia. Many are well-known indexes, but others are created by their fund company.

Examine each fund closely to avoid overlap within your portfolio.

While low cost is an advantage of most index funds, because they stick with a set portfolio and no real management is required, expenses can vary. The return is the performance of the index minus expenses to run the fund. Carefully consider the annual expense ratio, how closely the fund actually tracks the index and how tax efficient the fund is.

"Index funds are the core of many personal portfolios, especially those without a lot of money to diversify, such as a youngster's account" or a new Roth individual retirement account, said Mark E. Balasa, certified financial planner with Balasa Dinverno & Foltz in Itasca, Ill. "Unlike many funds that drift in style, with an index fund you know exactly what you've bought."

Balasa's clients usually invest in an S&P; 500 fund for diversification in large-cap U.S. stocks; a fund based on the MSCI EAFE (Morgan Stanley Capital International Europe, Australasia, Far East) index for international; and funds based on the Russell 2000 or S&P; 600 for smaller-cap stocks.


"Those close to or in retirement might not be as heavily exposed to the Nasdaq index as a younger person," Balasa said. "They may hold more in a bond index fund as well."

You also can invest in an index through exchange-traded funds that trade as stocks on exchanges. For example, ETFs that track the S&P; 500 include Spiders and iShares.

Unlike a mutual fund's once-a-day settlement price, an ETF allows you to trade at different prices throughout the day. But you pay a commission to a broker each time you trade, and there also can be a bid-ask spread.

"ETFs are a great solution for those who trade frequently or throughout the day," Kinniry said. "For buy-and-hold investors, a mutual fund makes a lot of sense."

Noting the more than 629 available index ETFs, Tjornehoj said investors can "slice and dice" the various regions or investment goals to a minute degree.

Andrew Leckey writes for Tribune Media Services.