Index Investing: Index Funds

|| This article is Part Two in a series on investing with index mutual funds. ||
||   I. SpeculationII. Index FundsIII. John BogleIV. Vanguard   ||
||  V. Moving to VanguardVI. Asset AllocationVII. Maintenance  ||

If attempting to choose a handful of specific companies to invest in is a losing strategy, what is the alternative?  Own a tiny slice of everything.

To accomplish this, you won't be trading in individual stocks; instead, you'l be investing in index mutual funds.  Investing in this way is much easier than you probably ever would have thought.  This article outlines the what, the why, and the how of investing with index mutual funds.

What is a Mutual Fund?

If you wanted to buy a single share each of Google, Apple, IBM, GE, Dow Chemical, Proctor & Gamble, Exxon Mobil, and Walmart today, it would cost you $1825, and because Google is currently trading at $870 per share, Google alone would make up nearly 50% of your portfolio.  As you can probably see, assembling a well-balanced, sufficiently diversified portfolio from individual stocks of well-known companies is massively expensive.  This is to say nothing of the difficulty and expense of rebalancing your portfolio as the values of these individual stocks go up and down.

A mutual fund is an investment vehicle that allows a group of investors to pool their money toward the purchase of investments.  These investments may be stocks, bonds, US Treasury bills, commercial paper, real estate investment trusts, or any combination of these or other securities.  Mutual funds are extremely popular: in the US, we have invested around $13 trillion (2011) in mutual funds, and they account for about a quarter of total household financial assets in the country.

Mutual funds are popular because they are an inexpensive, efficient, low maintenance means for even the smallest investor to assemble a diversified portfolio.  The mutual fund manager uses the pooled money to purchase individual securities in whatever combination is desired, and individual investors then buy shares of the mutual fund.  The fund manager also takes care of occasional rebalancing of the fund's assets.  Trading mutual funds typically does not involve a transaction fee, and unlike common stock, fractional shares of a mutual fund can be bought and sold without restriction.

A mutual fund manager is free to fill the mutual fund with pretty much whatever securities they would like.  Mutual funds file a prospectus with the US Securities & Exchange Commission, and this document must be made available to potential investors; it details the fund's objectives, management structure, performance history, and all fees associated with buying, selling, and holding the fund.  Always review the prospectus before buying a fund!

What is an Index Mutual Fund?

Some mutual fund managers serve as stock pickers, attempting to beat the market's returns, protect against big drops in value during economic downturns, or accomplish whatever other goal they think there might be demand for.  Other mutual funds are designed to follow a specific economic sector or geographic region, like pharmaceuticals or Latin America.

The mutual funds we're most interested in are those favored by Warren Buffett in Part One, Speculation: the index mutual fund.

Index mutual funds follow financial market indices.  You have probably heard of indices such as the Dow Jones, the NASDAQ, and the S&P500, but there are many others: the Russell 2000, the MSCI US Small Cap 1750, etc.  These indices are a basket of stocks, bonds, and other securities designed to  track the value of a particular section of the economy as representatively as possible.  For instance: the S&P 500 tracks the value of 500 large, publicly-traded US companies, while the NASDAQ follows 3,000 US and non-US companies, many of which are involved in technology.

Low-Cost, Automated, Diversified

While some actively-managed mutual funds may charge an expense ratio (annual management fee) of 2% of assets or higher, index mutual funds have extremely low management fees (0.02-0.30%) because their management is very simple and primarily carried out by a computer.  Combined with a general lack of transaction fees, an index mutual fund is the best way to keep your costs down and receive your fair share of the market's returns.

Because you can trade partial shares of a mutual fund, automatic investment is straightforward.  Mutual fund brokerages offer automatic investment programs in which a set amount of money is automatically transferred from your bank account to your investment account and used to purchase more shares on a set schedule.  By making your investing automatic, you greatly improve the probability of achieving your investment goals and remove the risk that you'll make poorly-timed investment decisions based on emotions.

And how's this for diversification: the largest mutual fund in the world is Vanguard's Total Stock Market Index Fund |VTSMX|.  This fund holds over 3,500 domestic stocks and is incredibly comprehensive:
The investment seeks to track the performance of a benchmark index that measures the investment return of the overall stock market. The fund employs an indexing investment approach designed to track the performance of the CRSP US Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq.
The even better news is that this fund is also one of the cheapest, with an expense ratio of 0.17% that drops to 0.05% when you have invested $10,000.

But why stop with the US?  By adding just one more fund—Vanguard's Total International Stock Index Fund |VGTSX|—you can own the entire world:
The fund employs an indexing investment approach designed to track the performance of the FTSE Global All Cap ex US Index, a free-float-adjusted market-capitalization-weighted index designed to measure equity market performance of companies located in developed and emerging markets, excluding the United States. The index includes more than 5,300 stocks of companies located in 46 countries.
The expense ratio is again very low, starting at 0.22% and dropping to 0.16% at $10,000.

Want to add bonds to reduce volatility?  Vanguard's Total Bond Market Index Fund |VBMFX| has you covered.

There are a few other indices you might consider holding, but these three are really all that's necessary and sufficient to achieve your investing goals.  In what ratio should you hold them?  A conservative heuristic is "your age in bonds" (i.e. 40% bonds for a 40-year-old) and the remainder split 3:1 between domestic and international stocks.  The specifics are the science of asset allocation, which deserves its own article.

Investing in index mutual funds will save you vast amounts of time, money, and stress.  Forget about daytrading, stock options, commodity futures, variable annuities, and all the rest of the needlessly complicated stuff: index mutual funds are the only type of investment product you need to understand to get started.  Many a college tuition and retirement has been financed entirely with money from mutual fund sales.

In the next article in this series, I'll talk about one of the greatest financial minds of the 20th century and tireless hero of Average Joe investors everywhere: John Bogle, inventor of the index mutual fund and founder of The Vanguard Group.