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Index Funds


Dear Dr. Don,
What is a stock index fund or an indexed bond fund? I want to open a Roth IRA and need to decide where to put my money.

I wonder if the T. Rowe Price Mid-Cap Growth Fund would be a good idea for my Roth? Is it a stock index fund? What about the T. Rowe Price Capital Appreciation fund? Is it a hybrid fund? Thank you. -- Martha Markets

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Dear Martha,
The stock market and the bond market have dozens of indexes, or groups of investments, that are used as benchmarks to measure how well a segment or sector of the financial markets is doing.

Most investors are familiar with the Dow Jones Industrial Average (DJIA) or the Standard & Poor's 500 (S&P 500) because the changes in these indexes are widely reported every business day.

Well, investors can invest in funds that buy what is in the index and earn a return that approximately equals the index's performance -- less any expenses associated with owning that fund. Instead of trying to beat the market, you own the market, or at least that part of the market represented by the index fund.

For example, the Fidelity Spartan US Equity Index (FUSEX) is a stock index fund based on the Standard & Poor's 500 Index. An investment in FUSEX will approximate the return of the S&P 500 over the same holding period less the mutual fund's annual expense ratio of .17 percent.

The Dow Jones Industrial Average is an index of 30 US stocks, while the Standard & Poor's 500 is an average of the 500 largest capitalization stocks of US based companies selected by the Standard & Poor's Index Committee.

The DJIA is an simple average of the prices of the 30 stocks in the index, adjusted for stock splits and stock dividends while the S&P 500 is a capitalization weighted index that not only considers the price of the stock but also considers the number of shares outstanding. Over a trillion dollars is invested in S&P 500 indexed investments.

The Vanguard Total Bond Market Index (VBMFX) approximates an investment in the Lehman Brothers Aggregate Bond Index. In this case the mutual fund doesn't actually own the more than 6,700 bonds that comprise the index, just a grouping of bonds sufficient to capture the average risk and maturity of the index to provide investors with a return that is close to the return on the actual index less annual expenses of .22 percent.

The T. Rowe Price Mid-Cap Growth fund (RPMGX) isn't an index fund. The fund manager selects stocks based on their size and their growth prospects. Market capitalization is the size of the firm based on the stock price times the number of shares outstanding. The growth emphasis relates to the companies' expected future earnings.

The T. Rowe Price Capital Appreciation fund (PRWCX) is a hybrid fund. That means that the portfolio manager invests in both stocks and bonds. This fund is not an index fund but you can invest in a hybrid fund that indexes its stock and bond investments. An example of an indexed hybrid fund is the Vanguard Balanced Index fund (VBINX).

Index funds will typically have much lower annual expenses than an actively managed fund. Index investors aren't trying to beat the market, just keep pace with the market index. A broad based approach to investing can keep the investor from taking speculative risks in an industry or sector.

I can't tell you whether an index fund investment will outperform the T. Rowe Price funds that you're considering, or any other actively managed fund for that matter. I like index funds for core holdings that will be held for long periods of time because of their low expense ratios and diversification.

You could always select the T. Rowe Price Equity Index 500 fund (PREIX) or another index fund from that fund family, but the annual expense ratio for PREIX, at .35 percent is roughly twice that of the Fidelity Spartan US Equity Index or Vanguard 500 Index.

An alternative to indexed mutual funds for your Roth IRA is to open a brokerage account and invest in Exchange Traded Funds (EFTs) like the SPDR Trust Series 1 (SPY) for the S&P 500 and others.

See IndexFunds.com for a complete review of the various investment indexes and the different mutual funds and ETFs available to invest in an index.

Editor's Note: Dr. Don holds investment positions in Fidelity Spartan US Equity Index
and Vanguard 500 Index funds.


-- Posted: Jan. 21, 2002




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