Indexing strategies have been around for decades, but many investors still don’t fully understand what a powerful tool they can be when constructing a portfolio. Indexing serves as a cost-effective way to potentially achieve long-term goals. From pensions and defined-contribution plans, to individuals and their financial advisors, all types of investors can gain access to broad market opportunities that indexing offers.
The first index funds were created in the 1970s, and their popularity has steadily increased to this day. In fact, investment into index strategies has continued to grow even as actively managed mutual funds have seen outflows.
What is an index?
Think about a stock index as “the market.” An equity index provides exposure to a relatively large number of stocks that represent a particular market. And there are different kinds of indexes to choose from. Some broadly cover the markets, for example the S&P 500 or the Russell 2000. An index may represent only large-cap stocks or only small-caps, or both. Some indexes cover international markets or specific sectors, such as financial companies or U.S. technology. The same holds true for bond indexes, if you’re looking for income.
In summary, if you are buying an index fund, you are effectively investing in the market.
How stock indexes fit in a portfolio
When thinking about the mix of assets in your portfolio, consider the risks that you are willing to take over a particular time period to realize your goals. For example, if you’re hoping for an early retirement or are saving to send your young child to college someday, you will likely need to have a core allocation to stocks over the long term.
What does core mean? It effectively means long-term “buy and hold” positions in your portfolio. Why stocks? Because the value of money erodes over time as inflation drives prices higher and pushes down the purchasing power of your dollars. To put that in perspective, a dollar earned in 2000 would now be worth 74 cents, and a dollar from 1980 amounts to just 35 cents today, according to the U.S. Bureau of Labor Statistics CPI Inflation Calculator.
On their own, stocks historically carry more market risk than cash and bonds. In the short term, stock prices can be volatile. But in return for this increased risk, there is the potential for a higher return.
But which stocks are the best to own over a long period of time? It’s difficult even for the pros to know exactly which stocks to buy when. Here’s where the beauty of stock indexes come in. Exchange traded funds (ETFs) and index mutual funds can be an effective way to buy the market in a low-cost, tax efficient manner and help you keep more of what you earn.
Portfolio construction is a lot like building a house. You need a strong foundation or else your house will fall over. Index funds can serve as the concrete blocks of your portfolio foundation so that your investment plan can stand the test of time.
Questions to ask
The quality of the index composition and the fund manager who runs it play crucial roles in determining your overall performance. In addition, the structure of the funds you choose can significantly affect your portfolio’s tax efficiency and ability to sell when you want to.
When evaluating index fund managers, consider these questions:
What trading strategies do they use to maneuver in changing markets?
How tax efficient are these products?
What’s the quality of the benchmark the fund seeks to track, and how does it compare to others?
There are many tools to consider in portfolio construction and asset allocation, but having a core of index strategies can be instrumental to potentially achieving long-term portfolio growth and the outcomes you desire.
Jane Leung is an iShares Asset Allocation Strategist for BlackRock.
Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal.
Index funds are not actively managed and will not generally attempt to take defensive positions under any market conditions, including declining markets.
Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders. This material does not constitute any specific legal, tax or accounting advice. Please consult with qualified professionals for this type of advice.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2016 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.