AKAMAI MONEY

By Deborah Adamson
Advertiser Staff Writer

Q: What is a stock index fund and how does it work? — Jon Arcinio, Pearl City

A: An index fund is a mutual fund that invests in stocks, bonds or other securities that make up an index, such as the Standard & Poor's 500. It is a popular way for do-it-yourself investors to manage their own money.

"Investing in index funds will not take all the risk and worry out of investing, but it will provide a way to invest that is much simpler, less expensive, and more productive than investments that require extensive investment knowledge and a good deal of luck," said Ron Wall, family economics specialist at the University of Hawai'i at Manoa.

To understand how an index fund works, let's define its characteristics.

Money in an index fund is invested according to an index. An index is a list of securities, such as stocks. By looking at the movement of the index, the investor gets an idea of what's happening in the market.

If you're making soup and you want to know if it's salty enough, you take a sip. That's enough to tell you whether it needs more salt or not. An index is like a sip of the market. Most indexes do not contain all stocks, but a look at how one index performs gives you an idea of the market's overall direction.

A popular stock index is Standard & Poor's, which is made up of the 500 largest U.S. companies ranked by market value, or market capitalization. Other well-known stock indexes are the Dow Jones Industrial Average (30 big companies), Nasdaq Composite Index (over 3,000 companies of various sizes) and the Wilshire 5000 Total Market Index (all U.S. stocks). The MSCI EAFE (Europe, Australiasia, Far East) is a well-known international stock index while Lehman Brothers Aggregate Bond Index tracks the U.S. bond market.

An index fund tracking the S&P 500 will buy the 500 stocks in the index. So its performance should closely mirror the index.

Investing in index funds has grown in popularity since most money managers don't beat the index against which their performance is measured.

In the 10-year period ending in October 2004, 97.6 percent of money managers failed to beat their benchmark index, said Mark Hebner, president of Index Funds Advisors, a fee-only financial planning firm in Irvine, Calif., that operates IndexFunds.com and IFA.com.

Another popular feature of index funds is their relatively lower fees. Since an index fund's investments are already set, it doesn't need as much hands-on treatment from a money manager compared to other funds. As such, these funds typically charge less in fees per year and in the past, they didn't carry sales commissions.

Unfortunately, as their popularity has grown — from their creation in 1976 to 700 today — that's changing.

Some index funds carry sales commissions, or loads.

Consider the Morgan Stanley S&P 500 Index fund

(SPIAX). It charges an up front sales commission, or front-load, of 5.25 percent, according to mutual fund research firm Morningstar in Chicago. So every time you put money into the fund, 5.25 percent will be taken out.

"It's still buyer beware," said Lesley Brey, a certified financial planner in Niu Valley.

There's also the annual fee charged by funds to pay for operations. This is called the expense ratio, which is expressed as a percentage of assets.

Look for index funds with expense ratios of no more than 0.5 percent, said Sonya Morris, a mutual fund analyst at Morningstar.

The largest mutual fund, which happens to be an index fund, is the Vanguard 500 Index (VFINX). Its expense ratio is 0.18 percent.

Alternatively, you might also consider a fast-growing sibling of index funds, the exchange-traded fund, or ETF.

An ETF is a security that's traded like a stock but reflects a particular index. Since it trades like a stock, you can buy and sell all day long and even short it. Unlike funds, where the minimum investment could run into thousands of dollars, the ETF minimum is the price of a share.

The drawback: since it's bought and sold through a broker, if you regularly invest money you'll have to pay brokerage fees each time, Morris said.

For more information on ETFs, there's a primer at www.morningstar.com.

When you're setting up a portfolio of index funds, make sure you're adequately diversified, Brey said.

So you might be in two index funds, but if they both track growth stocks, your investments are not truly spread out, hence raising the risks.

To see where indexes are invested, go to www.ifa.com/12steps/step8/step8page4.asp. Scroll down to Figure 8.14. For index fund allocations used by Index Funds Advisors, go to www.ifa.com

/portfolios. Click on the portfolio numbers, which reflect different risk tolerances, near the top.

Got a personal finance question? Contact Deborah Adamson at dadamson@honoluluadvertiser.com or 525-8088.