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Index Funds Explained

By Jane Leung, CFA, iShares Asset Allocation Strategist Indexing strategies have been around for decades, but many investors still don’t fully understand what a powerful tool they can be when constructing a portfolio. Indexing serves as a cost-effective way to potentially achieve long-term goals. From pensions and defined-contribution plans, to individuals and their financial advisors, all types of investors can gain access to broad market opportunities that indexing offers. The first index funds were created in the 1970s, and their popularity has steadily increased to this day. In fact, investment into index strategies has continued to grow even as actively managed mutual funds have seen outflows. Click to enlarge What is an index? Think about a stock index as “the market.” An equity index provides exposure to a relatively large number of stocks that represent a particular market. And there are different kinds of indexes to choose from. Some broadly cover the markets, for example the S&P 500 or the Russell 2000. An index may represent only large-cap stocks or only small-caps, or both. Some indexes cover international markets or specific sectors, such as financial companies or U.S. technology. The same holds true for bond indexes, if you’re looking for income. In summary, if you are buying an index fund, you are effectively investing in the market. How stock indexes fit in a portfolio When thinking about the mix of assets in your portfolio, consider the risks that you are willing to take over a particular time period to realize your goals. For example, if you’re hoping for an early retirement or are saving to send your young child to college someday, you will likely need to have a core allocation to stocks over the long term. What does core mean? It effectively means long-term “buy and hold” positions in your portfolio. Why stocks? Because the value of money erodes over time as inflation drives prices higher and pushes down the purchasing power of your dollars. To put that in perspective, a dollar earned in 2000 would now be worth 74 cents, and a dollar from 1980 amounts to just 35 cents today, according to the U.S. Bureau of Labor Statistics CPI Inflation Calculator . On their own, stocks historically carry more market risk than cash and bonds. In the short term, stock prices can be volatile. But in return for this increased risk, there is the potential for a higher return. But which stocks are the best to own over a long period of time? It’s difficult even for the pros to know exactly which stocks to buy when. Here’s where the beauty of stock indexes come in. Exchange traded funds (ETFs) and index mutual funds can be an effective way to buy the market in a low-cost, tax efficient manner and help you keep more of what you earn. Portfolio construction is a lot like building a house. You need a strong foundation or else your house will fall over. Index funds can serve as the concrete blocks of your portfolio foundation so that your investment plan can stand the test of time. Questions to ask The quality of the index composition and the fund manager who runs it play crucial roles in determining your overall performance. In addition, the structure of the funds you choose can significantly affect your portfolio’s tax efficiency and ability to sell when you want to. When evaluating index fund managers, consider these questions: What trading strategies do they use to maneuver in changing markets? How tax efficient are these products? What’s the quality of the benchmark the fund seeks to track, and how does it compare to others? There are many tools to consider in portfolio construction and asset allocation, but having a core of index strategies can be instrumental to potentially achieving long-term portfolio growth and the outcomes you desire. This post originally appeared on the BlackRock Blog.

Damage Control: Is It Too Late Too Become More Defensive?

A manufacturing recession doesn’t matter… until it does. Consider industrial production. For the third straight month, industrial production, which includes mining, utilities, as well as manufacturing, contracted. How anemic is American industry right now? The year-over-year percentage change provides a helpful snapshot of the weakness. Not surprisingly, media mega-stars routinely dismiss manufacturers, miners and utility providers as relics of yesterday’s economy. They maintain that consumers are the only ones who count in a consumption-based society. The erosion of the high-paying careers in those segments notwithstanding, might the rosy projections for household consumption be misleading? After all, retail sales (ex auto) pulled back 0.1% in December, even as economists anticipated 0.2% growth. We can look at consumer trends in a variety of ways. As I pointed out in my most recent commentary (1/12/16), year-over-year percent growth in personal consumption expenditures (PCE) has been declining steadily for roughly 18 months. Meanwhile, year-over-year percentage changes in retail sales (ex auto) emulate what is taking place in American industry. So what happened to the “clear-cut” benefit of lower oil prices? Weren’t they supposed to be a giant tax cut for the American consumer, prompting them to spend? Not when wage growth is tepid. And not when many households have chosen to increase their savings. It should not go unnoticed that the S&P SPDR Retail Index has quickly descended into bear territory. The SPDR S&P Retail ETF (NYSEARCA: XRT ) is currently down about 22.3%. Even more disheartening for those who had not become more defensive in their asset allocation over the past year? The price of XRT is lower than it was two years ago. Ironically enough, the question is no longer whether U.S. stocks have entered a bear market in the same way that the retail segment has. Indeed, Bespoke Research already demonstrated that the average large-company stock, the average mid-sized company stock and the average small-company stock have all surpassed the 20% bear market threshold. In the same vein, the median stock in the Russell 3000 and the Value Line Index show the same. The only question now is whether or not there will be enough buying interest in market-cap weighted indices like the S&P 500 and the Dow Jones Industrials to avoid a similar fate. The SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) does have impressive support at the 185 level. In my estimation, the best shot that the major benchmarks have in avoiding a “bear market headline” is the same injection that occurred during the euro-zone crisis in 2011. Specifically, nearly all of the U.S. indexes and overseas benchmarks fell 20%-40% during that summer. The Dow and the S&P 500 escaped a similar fate with depreciation of “just” 19%-19.9%, due to “well-timed” stimulus promises by the European Central Bank (ECB) and the U.S. Federal Reserve. Already, Fed fund futures have pushed out their anticipation of a second rate hike out to Q3 (July-September) from March. The market does not believe the Fed party line of 4 rate hikes in 2015. In fact, if the Dow and the S&P 500 do fall to significantly lower levels, one might anticipate the central bank of the United States reversing course; perhaps the notion of negative interest rates and/or QE4 might be introduced to the investing public. Historically speaking, however, the wildcard of a Fed reversal may not be enough to calm the nerves of panicky market-based participants. Take a look at this table for the S&P 500’s first five trading days in January. (Note: I won’t even incorporate the horrific second week that investors are dealing with right now.) The worst first five days for the S&P 500 occurred right here in 2016. But that’s not all. In the table, seven of the nine worst starts ultimately offered poor risk-reward results, either with additional losses or sub-par total gains through year-end. “Wait a second, Gary. Those other two years in 1991 and in 1982 show extraordinary price appreciation. Isn’t that reason enough to be optimistic?” Not if you recognize that the price gains that occurred in 1991 came at the conclusion of the 20% losses for the 1990-1991 stock market bear. And not if you realize that the price appreciation that followed in 1982 came at the end of the 27% losses for the 1981-1982 stock market bear. Right now, we’re not coming off of a 20% price collapse of the S&P 500. It follows that to the extent one wants to take the history of market direction into account, one would have to look at 2016’s prospects in an unfavorable light. I spent the better part of 2014 explaining the benefits of a barbell approach for a late-stage bull . We matched large-cap U.S. stock assets like the iShares Core S&P 500 ETF (NYSEARCA: IVV ), the Health Care Select Sect SPDR ETF (NYSEARCA: XLV ) and the iShares S&P 100 ETF (NYSEARCA: OEF ) with longer-term investment grade bonds like the Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ), the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) and the SPDR Nuveen Barclays Municipal Bond ETF (NYSEARCA: TFI ). By May of 2015, I expressed the tactical asset allocation changes that I believed were necessary in an unfavorable risk-reward environment, encouraging investors to lower their overall exposure to risk assets . Trying to exit markets during panicky sell-offs rarely proves beneficial. That said, if you believe that you may have been too assertive with your exposure to riskier holdings, you might wait for an inevitable bounce higher. One can work his/her way to a more defensive stance until the fundamental, technical and economic backdrop improves. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.