Inscrutable Index Funds

by Stephen Kass on July 14, 2012

With the stock market’s rise, index funds have grown to gigantic proportions. But
they aren’t right for all investors. By understanding the investment-management process
of index funds CPAs will be better able to advise their clients or employers.

An index fund is a mutual fund that buys the same securities as those in an index.
For example, S&P 500 index funds track the total return of 500 of the largest public
company stocks in the United States. The stocks that make up that index are determined
by the six-member S&P 500 index community.

There are a number of reasons why investors are attracted to index fund investing.
The S&P 500 has consistently outperformed most equity portfolio managers in recent
years. Stock turnover is low, so expenses are also low, giving index funds a head start in
performance. Low securities turnover also results in better timing of realized gains.

There is, however, a downside to investing in index funds. Because stock
selection is not based on fundamentals, the fund usuall7 plays homage to past
performance, not future potential. In addition, the fund is not diversified in terms of
market capitalization, the investment approach in inherently passive; and there is no risk
control in a down market.

Active portfolio management may be a viable alternative for some investors.
Active managers serve their clients best by employing a sell discipline that locks in gains
and redeploys assets to more attractive investment opportunities. CPAs should be careful
when recommending index funds. The best way to fulfill an investment goal is through
thoughtful and deliberate investment choices.

Leave a Comment


5 + eight =

Previous post:

Next post: