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Getting Active with Index Funds

Jason Stipp

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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Stipp: So important to keep an eye on those expenses given that they are very similar funds. So I want to talk a little bit about how you might use these funds in a portfolio, because it's conceivable that you could construct a whole portfolio with nothing but index funds, right?

Benz: That's right, and I think that when Buffett talks about that being a really nice low cost way to go, the ultimate expression of that would be an all-index portfolio, so maybe you're using a total world stock market index to give you U.S. and foreign stock exposure, or maybe separate foreign and U.S. stock index funds as your core equity exposure. And then just going with the total bond market index fund for your fixed-income exposure, and then making sure you have any cash reserves that you need as well. So that's the ultimate in low maintenance hands-off.

Incidentally, Jason, I've been hearing from a lot of retirees, who have gotten a lot more interested in ETFs and index funds because they are concerned about leaving a very low maintenance portfolio for their spouses, who maybe aren't so into investing. So for people who have been active investors their whole lives, that low-maintenance all index portfolio can be very appealing for later in life.

Stipp: So for folks who are inclined to be a little bit more hands-on, you normally think of the index vehicle as being a very passive vehicle, but they don't necessarily have to be used passively. What are some other ways that you could incorporate index funds in a portfolio of holdings?

Benz: We hear from a lot of people who use a "core and explore" strategy, and I think that term was popularized by Schwab. There are different versions of it, but essentially it means you use index funds or some sort of strategic long-term core, and then you maybe use a more tactical approach or dabble in more specialized, perhaps even speculative funds with that "explore" portion.

So people are using index funds for both roles, for both the core roles, some of the core funds that we discussed earlier, and then maybe they are using some of the more niche funds around the margins of their portfolio, so commodities would be a good example where people are using ETFs to fill in that "other" slice of the portfolio.

Stipp: So a couple of the benefits of that would be, first of all, they are cost vehicles, and secondly they are pretty pure as far as what they are accessing, because they are index funds, so if you have a certain take on a certain area of the market, you think that it's undervalued, you can target that for that portion of the "explore" part of the portfolio?

Benz: Exactly. It's that pure-play that can be very appealing for tactical investors. You're not going to find an ETF hanging on to a bunch of cash when you wanted that pure-play exposure. So what you see is what you get with an ETF--and the costs can be nice and low, and you may also be able to trade in and out of them without paying a commission, which can be attractive, too.

Stipp: So, Christine, based on some of the research from Morningstar, if there were some ways that you would think that investors could consider tinkering with their portfolio or shifting a portfolio with index funds, what are some of the themes that they might want to think about in today's market?

Benz: Well, when you look at the themes that are bubbling up from our equity researchers these days in a fairly valued market, our stock analysts are seeing some of the larger companies as being more attractive currently, and some of the wide-moat companies in particular, so someone might consider emphasizing those companies possibly by using S&P 500 Index ETF versus a total market ETF. The total market ETF will give you some of those small and mid-sized stocks. 500 will mostly be the larger companies. Or you could really look at targeted mega-cap exposure with an index fund like Bridgeway, the Large Cap 35 index that Bridgeway has. So that would be one idea for getting a more tactical take on the equity universe right now.

Stipp: What about on the fixed-income side?

Benz: Well, one approach that our ETF team has espoused is, they've been nervous about Treasuries like Bill Gross and not really liking that part of the bond market. So they've actually chosen to build portfolios that consist of corporate bonds and mortgage-backed bonds, but cut out that Treasury piece, which is such a big piece of total bond market index funds. So for people who are similarly nervous about Treasuries, but want to use index funds or ETFs. That's one idea.

Stipp: Okay, and what about for folks who like their active managers or like the active management route, is there a role for index funds in their portfolio?

Benz: I think there is, Jason, and I've often shared this Vanguard research that they did a few years ago where they looked at thousands of combinations of portfolio holdings, and what they found was that even for people who are very astute fund pickers, so good selectors of active managers, they found that holding about 25% of that portfolio in index funds to provide that ballast and make sure that you have broad market exposure no matter what your active managers are doing. They found that a component of index funds was additive even for those folks who were astute stock-pickers.

Stipp: All right, Christine, well, thanks for the tip on putting a piece of advice from Warren Buffett into action, and for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.