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Index funds can be great tool for small investors, but choose wisely

NEW YORK -- If you've got better things to do than pour over the finer points of your stock portfolio, and you don't care to study the performance records and investing styles of mutual fund managers, chances are you've invested in an equity index fund.

Good for you. These passively managed baskets of stock will give you quick, easy and inexpensive exposure to a broad swath of the market, and more often than not, provide better returns than actively managed funds, which have to charge higher fees so they can pay their stock-pickers -- who aren't always right. An index can be a great first fund for beginners, and many people, including some very astute investors, rely on them exclusively. But not all indexes are the same, and depending on which one you hold, your stake in the market might be more limited than you realize.

About a third of the $7.4 trillion invested in the nation's mutual funds is held in passively managed index funds, and they are growing more popular all the time. This is reflected in the rising asset levels of exchange-traded funds, which track indexes but differ from mutual funds in that they are traded like stocks.

The biggest fish in the indexing world is the Standard & Poor's 500, which many investors consider to be the best overall snapshot of the U.S. equity market. Some $1.1 trillion in passively managed assets are pegged to it. It's replicated by an ETF sold through iShares and dozens of mutual funds, including the Vanguard 500, now the largest retail mutual fund in the nation, with assets topping $96 billion.

If all of your stock exposure came from the S&P 500, however, you'd be ignoring huge parts of the market, including thousands of small and microcap stocks, which led Wall Street's most recent rally. You'd also have to wait years before some up-and-coming companies met the standards of S&P's index committee, which reconsitutes the list on an as-needed basis using a variety of factors, including liquidity, price and market-cap -- typically $4 billion or higher.

"The biggest mistake new investors make, besides just listening to someone who says they can pick hot stocks for you, is thinking that indexing equals an S&P 500 index fund," said Tom Coyne, editor of the Index Investor newsletter. "I think you always start with the broadest-based index, and if you're going to tilt your portfolio away from that, fine, but make sure you're doing it for a reason."

There are many ways you could broaden your equity exposure beyond the large-cap focused S&P 500. You could buy funds that track the S&P MidCap 400 and S&P SmallCap 600 -- which are also selected by the S&P committee. For more sophisticated investors, this might be appealing, because you can raise or lower your exposure to different market caps depending on your strategy. Or you could get exposure to all three by investing in a fund that tracks the S&P 1500.

If you don't care for the idea of having a committee of people choose which stocks you own, you might like the indexes offered by the Russell Investment Group. Russell tracks 3,000 domestic stocks, and simply lists them from largest to smallest. The Russell 1000 is a large-cap index, and the Russell 2000 is a widely held small-cap index. You could own both by investing in the Russell 3000.

If neither of these sound big enough to you, then you should take a look at the Dow Jones Wilshire 5000, the broadest possible slice of domestic stocks you can buy. The Wilshire 5000 -- which actually holds 5,035 equities -- tracks virtually every publicly listed U.S. stock, and adds new names each month, as companies stage initial public offerings. Google Inc. (Nasdaq: GOOG) was among those added last week.

The Dow Jones U.S. total market index, which holds just over 1,600 stocks, is another option.

One of the benefits of owning broader market indexes is that you're more likely to get early exposure to young companies. Russell recently announced plans to add IPOs on a quarterly basis. Forty-eight IPOs will be added to its indexes on Sept. 30, including Google and Freescale Semiconductor Group, which will jump directly to the large-cap Russell 1000. Previously, IPOs were added as part of Russell's annual reconstitution process.

When stocks were added to indexes in the past, their prices popped higher, a phenomenon known on Wall Street as the index effect. As index funds prepared to add stocks to their portfolios, large traders bid them higher, arbitraging the difference.

A recent study by S&P suggests this trend is on the decline, however, in part because of changes in the way index funds handle additions. Instead of buying lumps of shares at once, many have spread their purchases out over several days, before and after the change officially takes place. This ultimately minimizes costs to the index fund's investors, lowers volume and essentially "makes it harder for the arbitragers," to play their game, said S&P index strategist Srikant Dash.

"Changes to an index will always have some negative impact, because that means index funds have to trade; any change results in turnover, which in turn results in the index effect," Dash said. "The implication is that this has diminished, and that's good for index fund investors."


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