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Index funds have revolutionized the way people invest. By giving investors a low-cost way to invest in a wide variety of different types of assets, index funds have efficiently given many investors ways to get into investments they might otherwise have overlooked.
Nowadays, you can put together an entire diversified portfolio composed solely of index funds. The rise of exchange-traded funds has led to an explosion in the number of index-tracking investments available to you. As easy as it is to have an all-index portfolio, you may be curious: Is it a good idea?
Why indexing is great
For those who are easily intimidated by investing, few things are simpler than index funds. Pick an S&P 500 fund, for instance, and you'll never have to wonder why your portfolio went down when the business section says the stock market went up. By owning fewer than a dozen funds, you can implement an asset allocation strategy that gives you exposure to stocks both large and small, domestic and international, as well as bonds, real estate, and any number of other asset classes -- all at a fraction of the cost you might pay for active management.
If you choose never to buy anything but index funds, then you're already managing your finances better than many people ever do. Before you decide index funds are all you'll ever need, though, there are a few things you should know.
An index fund is only as good as the index
The key to index investing is the premise that matching a given index's returns is adequate for you to reach your goals. Whether that's true depends on how good the index is, in terms of both return and risk.
It wasn't that long ago that the only index funds available tracked broad indexes. Investors were familiar with those indexes, although they didn't necessarily understand exactly how they worked. Typical investors could understand that the S&P 500 included roughly 500 of the largest companies in the U.S. -- but they might not realize that a huge company like Chevron (NYSE: CVX ) has more than 20 times as much influence on the index as a smaller company such as Coach (NYSE: COH ) or Southwest Airlines (NYSE: LUV ) .
But now, index-tracking ETFs are everywhere. The indexes they follow, however, aren't necessarily the popular ones you see every day. In fact, many ETFs create their own specialized indexes to track. For instance, the Claymore Global Solar Energy ETF (NYSE: TAN ) includes about 25 solar companies from the MAC Global Solar Index, including First Solar (Nasdaq: FSLR ) , Suntech Power (NYSE: STP ) , and MEMC Electronic Materials (NYSE: WFR ) .
You're not likely to see these specialized indexes published anywhere, except perhaps in connection with the ETFs that track them. In addition, there's no guarantee that those indexes will perform the same way an overall industry does. If the index leaves out or underweights a company that ends up dominating its industry, then your returns will suffer.
Some assets are better suited to indexes
Finding a high-quality index is only half the story. Indexing also works best in areas where active management doesn't add much in extra returns.
A couple of years ago, Fool retirement expert Robert Brokamp looked closely at index funds of various types. He found that bond index funds were most likely to outperform their actively managed counterparts, while specialized funds focusing on areas like emerging markets or real estate investment trusts (REITs) tended to benefit more from active management -- even given higher costs.
Index funds require investors to make a trade-off: You'll never do worse than the market, but you also give up the greater potential returns of actively choosing particular stocks. During a market environment where the indexes are getting slaughtered, you might not want to settle for losses. But in the long run, you could do far worse than earning the market's average return.
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