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By Jason Stipp | 05-03-2011 05:00 PM

Getting Active with Index Funds

Buffett recommends index funds for the hands-off investor, but they can also serve the more tactically minded.

Jason Stipp: I am Jason Stipp for Morningstar. At last weekend's Berkshire Hathaway Annual Meeting, Warren Buffett again sang the praises of index funds for the more hands-off investor, the investor who maybe doesn't want to curl up with a big 10-K or 10-Q.

But how to choose an index fund? There are a lot of options out there. So here with some tips on purchasing a fund, then also how you might use them in a portfolio is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So the first question for you, Buffett did say that index funds were a good option for a more hands-off investor, but there are a lot of index funds out there. So it's not as simple as just picking the index fund off the shelf. How do you start to discriminate between these funds?

Benz: Well, it's a good question, Jason. Funds use lots of different strategies to constructing their indexes, and they might also focus on different sub-parts of the market. So you want to understand how an index is constructed. The bulk of investment assets in index funds and ETFs at this point are in so-called market-cap-weighted indexes, meaning that they simply track a market segment holding-for-holding by its weight or market value within that benchmark. That's where most of the assets are currently.

But there are other flavors of index funds. Some use so-called fundamental strategies, meaning that they are actually looking at fundamental characteristics like earnings or dividends to construct the index. Then there are other index funds that are actually equal-weighted. So they take equal sized positions in their holdings.

So you need to understand what you are getting.

Stipp: Important to know how the index is constructed. What about management and fees and things like that? What are some benchmarks there?

Benz: Management I say don't pay a lot of attention to. You want a firm that generally has expertise in index fund management, but beyond that I don't think you have to pay a lot of attention to manager tenure, because if a firm has that baseline capability they should be able to provide pretty good tracking, and if they are not, it's going to be evident right off the bat. So you don't have to worry too much about that in contrast with active funds, which is one reason that index funds are such nice hands-off vehicles.

Expenses are a lot more important of a consideration. So, these are essentially commodity-type products, so the cheaper, the better. You want to focus on the lowest price tags that you can. That's why Morningstar's favorites have tended to depend on how cheap can they go, and we've had over the past few years in the traditional mutual fund index world a Vanguard, Fidelity, and Schwab all competing for cheapest fund provider, which has been really good for fund shareholders.

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