At the height of the stock market boom in 1999, a friend of mine complained that he didn’t have enough time to do the necessary homework to invest. He felt that investment opportunities were slipping by while his money was gathering dust in a money market account. He could have solved (and simplified) his problem by investing in an index fund or exchange-traded fund.

Discovering index funds

Index funds are sometimes called passively managed funds. Index fund managers try to closely track the performance of a target market index. Index funds buy and hold all, or a representative sample, of the securities in a particular index. The composition of the portfolio of the index fund is determined by the index it is trying to mirror. For example, a Standard & Poor’s 500 index fund will match the percentage of stocks held in the Standard & Poor’s 500 index. In contrast, in an actively managed fund, a fund manager tries to outperform similar funds or an appropriate market benchmark. Actively managed fund managers use expensive research, market forecasts, and their own judgment and experience to buy and sell securities. This expertise makes the operating costs of a managed fund higher than a passively managed index fund.

The operating costs for passively managed index funds are often 0.20 percent. In addition to their low cost, the appeal of index funds is twofold. First, the index fund will match the returns of the index it mirrors. If the market does well and the value of the index increases, the investor does well. The second reason investors like index funds is that some indexes better reflect their individual investing objectives. The downside of index funds is that investors will never have the opportunity to significantly outperform the market. For more information about index funds, see the following:

IndexFunds.com (www.indexfunds.com), shown in Figure 6-2, is a helpful all-purpose online resource for index mutual funds. You’ll find a beginner’s message center, ten favorite indexes, and useful articles and links. Use the screener to search for investment candidates using criteria such as expense ratios, net assets, or five-year returns.

The Index Investor (www.indexinvestor.com) is a useful Web site for registered members who are seeking better index fund performance through asset allocation. IndexInvestor.com is divided into free and subscription resource areas. Subscriptions are $25 per year.

Vanguard (flagship2.vanguard.com/VGApp/hnw/FundsStocks Overview) features the Vanguard 500 index fund, which has been around for more than 25 years. You can read all about the benefits of indexes online.

Becoming aware of exchange-traded funds

Exchange-traded funds are passively managed funds that are traded on stock exchanges. A share of an exchange-traded fund is a share of a unit investment trust. Unit investment trusts are formed by investment companies with the intention of acquiring a portfolio of shares to be passively managed over a fixed period. The trust is then terminated.

According to The Wall Street Journal, as of September 2004, exchange-traded funds had combined assets of $180.8 billion, up 20 percent from $151 billion in December 2003. To create an exchange-traded fund (ETF), investment companies gather stocks or fixed income securities into one basket and then sell shares in the trust on a stock exchange. In other words, ETFs trade like stocks and can’t be abused by market timers.

As of September 2004, there were 143 ETFs. ETFs always include securities that are included in an index. ETFs come in several different types and are based on broad market sector indexes and international indexes. The following are a few examples:

Spiders: Track the Standard & Poor’s Deposit Receipts (SPDR, pronounced “spider”).

Cubes: Track the NASDAQ 100 of big nonfinancial stocks using the ticker symbol QQQ — hence the name cubes.

Diamonds: Track the Dow Industrial Average using the ticker symbol DIA — hence the name diamonds.

Vipers: The Vanguard Group has launched Vanguard Index Participation Equity Receipts, know as Vipers. Each Viper is a new class of shares of one of the company’s well-known index funds. The underlying portfolios are equal, though fees and other features are different from those of the Vanguard funds.

ETFs are inexpensive to own. Expenses for an ETF are usually 0.4 percent, compared with 1.4 percent for the average equity mutual fund — but you have the expense of the broker. If you follow dollar-cost averaging, your brokerage fees can quickly add up. On the other hand, you don’t have to worry about a minimum investment. Other advantages of ETFs include

The ability to buy and sell at any time during the trading day

Instant exposure to stock portfolios of your choice: You can select an ETF that meets your specific investor objectives.

The ability to buy on margin: These purchases are generally subject to the same terms that apply to common stocks.

No sales load: You still have to pay a brokerage commission.

No high management or sponsor fees

No minimum initial deposits

Potential tax efficiencies: Because ETFs transfer securities between investors, there are no tax consequences to the fund. For more information on exchange-traded funds (ETFs), see the following Web sites:

iShares (www.ishares.com) offers online tools such as the ETF Allocator, which allows you to create a portfolio of ETFs based on the Dow Jones U.S. Sector and Total Market Indexes. This company owns the iShares Russell 2000 Index Fund, which seeks investment results that, before expenses, generally correspond to the price and yield performance of the Russell 2000 Index.

Investment Company Institute (www.ici.org/funds/abt/index.html) is a national association for mutual fund companies that provides answers to frequently asked questions (FAQs) about exchange-traded funds. You also find useful industry statistics, investor education, and industry news.

American Stock Exchange (www.amex.com) offers a market summary of all ETFs, product information on specific ETFs, new listings of ETFs, an ETF screen and return calculator, and investor education. Additionally, you can download information about all of the American Stock Exchange– traded ETFs and end-of-the-day ETF prices. At the Home Page, click ETFs in the left margin.