Index investing has become quite popular with individuals. On the surface, there are many benefits to this passive approach to investment management. Index funds are attractive because they are fairly easy to understand, offer immediate diversification and carry low expenses and fees. Index investing is generally safer and can smooth out the ups and downs you might experience from investing in individual companies. Moreover, recent studies have shown that simple buy and hold index strategies regularly outperform actively managed funds.
However, index investing does not necessarily mean buying a broad market index fund and forgetting about it. Constructing and managing a proper portfolio, even if it consists primarily of index funds, requires some knowledge of asset allocation, diversification and rebalancing.
An index fund buys the same stocks as the index it follows. Common indexes include the Dow Jones Industrial Average and the S&P 500. However, analysts have created hundreds of indexes to reflect a variety of different market segments and asset classes. This variety offers investors the opportunity to construct diversified portfolios of index funds using an asset allocation strategy that aligns with their objectives, time horizons and tolerance for risk.
Proper asset allocation is important because markets go through cycles and investors should be exposed to a number of different asset classes at all times. Being diversified can help smooth out the bumps in the market over time. It also reduces the chances of sustaining significant losses by being too concentrated in any one sector.
Using index funds in your portfolio does not however alleviate you from the responsibility of understanding the underlying indexes, how a fund tracks the index and how it fits with your overall asset allocation strategy. As with individual stocks and bonds, developing an appropriate asset allocation with index funds takes research and understanding. You must decide not only how much to put into stock index funds versus bond index funds, but also the types of stocks and bonds you want those indexes to follow as well as the percentages of each to include in your portfolio. The choices of stock indexes may include domestic versus foreign; large cap versus small cap; developed versus emerging markets. The bond index fund choices may include the type of bond – corporate versus municipal, average time to maturity or “duration”, and foreign or domestic. In addition, you may want to consider indexes that follow alternative assets such as gold, real estate or energy.
After determining your strategic asset allocations and the indexes that support it, further research is required to understand the particulars of the funds that claim to track the indexes you select. Not all index funds are created equal when it comes to performance, even if they are supposed to track the same index. The differences result from a variety of factors such as expense ratios, portfolio turnover, transaction costs and investment strategy.
With respect to investment strategy, not all index funds invest 100% in the securities of the index they track, or may hold only a limited number of securities as representative of the index. In fact, most funds invest in only a portion of the index. If a fund, for example, invests only 80% of its assets in the underlying index that means that 20% of its portfolio may be held in other types of assets, even cash.
Index funds may also differ in how they approach weighting of the companies that make up the index. Traditionally, index funds are weighted by market value, with bigger stocks accounting for more assets. If the index itself is weighted by market value, such as the S&P 500, this approach will best reflect the index. Some newer funds, in an attempt to outperform an index, hold an equal weight of each stock in the benchmark. Other funds weight stocks according to fundamental factors such as dividend yields. By changing how stocks are weighted, the performance, relative to each other and to the index can vary dramatically. This variance means that funds in a portfolio must be matched with each other to achieve the desired outcome or could expose the portfolio to unexpected results. The increased uncertainty may add to your overall investment risk.
Another consideration for index investing is periodic portfolio rebalancing. This means adjusting your holdings – that is, buying and selling certain index funds – to maintain the asset allocation you established when you initially constructed your portfolio.
Rebalancing forces you to take profits from investments that have increased in value and buying those assets that have not gone up or declined in value. It is a systematic way to “buy low and sell high.” Periodic rebalancing based on predetermined criteria helps take emotion out of the process. Reducing or adding exposure to asset classes when valuations have skewed too far is an important aspect of passive index investing.
Rebalancing is also a good time to review the index funds in your portfolio. You may want to research alternatives to poor performing indexes and consider if your overall asset allocation continues to support your goals and time horizon.
Passive index investing is attractive on many levels including low costs and simplicity. However, successful investing, even if you are using a passive strategy does not mean set it and forget it. Understanding the basic principles of asset allocation, diversification and rebalancing are still important for success.