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Index Funds

August 2005
Index Funds

They're Cost-Efficient. But Are They A Good Value?

Index funds rose to popularity among investors during the bull market of the last decade, in part because they offered a relatively cost-efficient way to tap into the stock market returns of the 1990's. Today, many index funds remain popular with investors, even after the stock market suffered three consecutive down years to begin this decade.

But are index funds a good value? Consider that when you buy an index fund, you are essentially getting overall market performance. An index fund will generally do no better or no worse than the market index it tracks. Therefore, if your investment goals can be met with market performance, index funds could potentially fit well in your portfolio.

What's the downside to index funds? An index fund can sometimes be over-weighted in a particular stock or sector of the market. In a capitalization-weighted market index such as the S&P 500, bigger stocks generally make up more of the index and have a greater impact on its performance. Thus, index funds pegged to a cap-weighted index will also own more shares of the largest stocks in the index, and changes in the share prices of these large stocks could have a bigger impact on the returns of the index funds.

For example, consider what happened to S&P 500 index funds at the end of bull market in the 1990's. Many were over-weighted in technology stocks that appreciated in the mania of the dot-com boom. When the dot-com bubble popped, many technology stocks fell harder than stocks in other sectors of the market, and index funds that had become overexposed to the technology sector suffered significant losses.

Another downside to index funds: they may be vulnerable to losses if a particular stock in the index runs into trouble. An index fund may not be able to sell shares in a troubled company, unless it falls out of its index. On the other hand, an actively managed fund might be able to sell a position in a troubled company whenever the fund manager chooses.

What's the best approach to take with index funds? Of course, it depends on your individual investment goals. And index funds can provide market returns with expenses that are typically lower than those associated with actively managed funds. However, diversifying your portfolio among different types of index funds, supplemented by a few well-run actively managed funds, may also provide you with more balance from market fluctuations.

Please note that all mutual funds are investments involving risk and are offered by prospectus only. Investment return and principal value will fluctuate so that upon redemption an investor's shares may be worth more or less than original value. An investor should carefully consider the investment objectives, risks, charges and expenses before investing. The fund prospectus contains this and other information about the investment company. For a copy of the prospectus, please contact your financial advisor. Please read the prospectus carefully prior to investing.

Moneywise is hosted by Rajesh Jyotishi with Shalin Financial Services, Inc.

An Investment Advisor Representative of FSC Securities corporation. A Registered Broker Dealer. Member of NASD/SIPC. For questions he can be reached at 770-451-1932, ext. 101

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