FIN 408 Index Funds

1
FIN 408 - Index Funds

• Index Funds Unmanaged funds seek to replicate
  the performance of a designated index (e.g. SP
  500, Russell 2000, Wilshire 5000)
• In 1976, Vanguards founder John Bogle offered
  to the public Index 500.
• Not actively managed mix of securities changes
  only when the benchmark index changes.
• Fees and trading costs are significantly lower
  than the actively managed funds.

2
Index Funds

• Vanguard 500 has the lowest annual expense - 18
  cents per 100 Morgan Stanley SP 500 Index fund
  has 5.25 load and an annual expense of 69
  cents!!
• Any domestic index fund running annual expenses
  more than 50 cents per 100 is perversion of the
  indexing concept.
• In 2003, 300b in asset and 323 available index
  funds.
• Popularity of Index funds 80 of the fund
  managers (primarily equity funds) do not
  outperform the SP 500 index.

3
What index to Follow?

• SP 500 collection of bigger companies with
  market capitalization ranging from 500m to
  300b.
• Wilshire 5000 collection of big and small
  companies - nearly 7000 stocks taded on NYSE,
  AMEX, NASDAQ and other exchanges.
• Morgan Stanley EAFE index.

4
Index Funds Objectives

• The most common Index Funds are

5
Emerging Markets

• Emerging Markets Index Fund Attempts to
  replicate Morgan Stanley Emerging Market Free
  Index
• Primarily invests in 12 developing countries,
  may hold shares of hundreds of firms.
• May face liquidity problem as buying and selling
  stocks in developing markets are difficult.
• Administrative costs, trading costs, and other
  fees are higher than domestic funds.
• Faces significant foreign exchange risk.

6
Enhanced Index

• Enhanced Index Fund managed fund that attempts
  to beat the performance of the benchmark index by
  at least 0.1 but not more than 2 percent
• If the fund performance exceeds 2 percent, the
  fund is considered as stock fund
• Enhanced performance is accomplished by using
  variety of strategies
• Buy all securities in the index but assign more
  weight to favorite stocks or sectors that are
  expected to outperform the index
• May not buy all securities in the index. Buy

7
Enhanced Index

• substitute securities with similar
  characteristics that are considered to be
  currently undervalued.
• May invest in options and futures
• Actively managed fund. Expenses are higher than
  unmanaged index funds.
• Fund performance my be affected by higher
  expense.

8
Large Cap/Small Cap/L-T Bond

• Large Capitalization Index Fund Fund seeks to
  track the performance of SP 500 Index.
• Long-term Bond Index Fund Fund seeks to
  represent long-term bond, 20 to 30 years,as
  represented by the Lehman Brothers Long-term Bond
  Index.
• Small Capitalization Index fund Tracks
  performance of companies with capitalization less
  than 1b. Benchmark is Russell 2000. When index
  adds/deletes stock because of their
  capitalization, fund sells/buys at that time and
  realizes capital gains.

9
Total Market

• Total Market Index Fund Fund seeks to replicate
  the performance of the broadest measure of the US
  stock market - Wilshire 5000 Index. Tracks
  approximately 7000 stocks.
• Also known as Extended market index. Most
  passive form of investing.
• Because the index is so broad, it is less
  influenced by the performance of large cap
  tracks more closely the returns of small cap and
  mid-cap stocks.

10
Fund of Fund

• Can a market index fund or a blend of them beat
  the market?
• Fund of Fund A mutual fund that invests in a
  group of top performing funds. Idea is appealing
  - the manager chooses the best of the best .
• Craig Isrealsen (Forbes, Feb. 3, 2003) compared
  Total Index return with the return of Vanguard
  500, the Dreyfus MidCap, and the Vanguard Small
  cap funds. Beginning in 1993 to now, the mix of
  three fund would have produced an average annual
  return of 9.6, a full one percent better than
  the Total Index Fund.

11
Fund of Fund

• Fund of Fund can provide instant diversification
  and asset allocation among different countries
  and asset classification.
• May incur two sets of expenses. i) expenses
  related to fund of fund ii) expenses that the
  best performing funds will charge your fund.
• This double charges will be in the fund
  prospectus.
• Some fund houses are trying to avoid double
  charges by creating a version of fund of fund
  from their own funds
• Charles Schwab is giving a new twist to fund of
  fund called fund of best or top fund managers.
  Eight to

12
Fund of Fund

• ten top performing investment advisers from
  OneSource will pick one or two stocks that will
  make up a specific funds portfolio. Focus is to
  lower cost.
• Performance has varied widely mainly because of
  fees and expenses
• Covariance of funds may be an issue.