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TYPES
OF INDEX FUNDS
Once
you have become convinced of the efficiency and utility
of index funds in achieving financial goals (see Evidence
and proper asset allocation),
the next big task is to become familiar with the major types
of indexes and corresponding index funds and how they can
be combined to meet investment goals. Below is a discussion
of the primary asset classes/indexes utilized to reflect
the investable asset universe and the corresponding index
funds available to permit portfolio construction from a
mixture of these core asset classes. Note! Not all available
index funds are utilized for every portfolio. A select mixture
of index funds is utilized to meet specific investor needs..
We have discussed at proper asset
allocation the concept of Index Funds as building
blocks. Instead of a focus on individual stocks
or bonds, index funds are generally structured in terms
of asset classes, that is to say primary groupings of securities
that divide the investable asset universe into core components
or “building blocks”. Each core asset class
can be considered as a unique building block in portfolio
construction. Each core asset class has a unique set of
investment characteristics that are highly useful in achieving
a particular investment-planning goal. Once you have a handle
on the primary building blocks, an investor or investment
advisor can combine the building blocks to obtain a particular
blend or “asset allocation” depending on the
goals of the portfolio. This process of determining a proper
asset allocation plan is extremely important and is discussed
in some detail under proper asset
allocation.
The following is a representative list of asset classes.
While not exhaustive, the following core asset classes (and
corresponding indexes and funds) represents a classic division
of the investable asset universe into the core building
blocks that are often utilized in constructing an asset
allocation plan:
Domestic Stocks (Equities)
Investment can be made in an index fund that reflects investment
in nearly the entire US stock market. For example, the Wilshire
5000 is an index that mirrors the entire investable US stock
market and a number of index funds exists that are constructed
to reflect the performance characteristics of this entire
US stock market.
For portfolio planning purposes, however, an investor or
investment advisor may wish to emphasize one aspects of
the total US stock market over other elements, that is provide
an investment “tilt” in one direction or another.
The broad asset class “US stocks” is commonly
divided into the following sub-classes:
Large Capitalization Stocks
a) Large capitalization refers to a division of the US
investable stock universe into the larger companies as
distinguished from small companies. Each index varies
slightly in the cut-off point and selection criteria.
For example, the S&P 500 stock index is an index that
generally replicates the performance of the largest 500
companies in the US. The median market capitalization
of companies that constitute this index is around $8 billion
and accounts for 78% or so of the total US investable
stock market.
b) Small Capitalization Stocks
Small capitalization refers to a division of the US investable
stock universe into the small companies as distinguished
from large companies. Each index varies slightly in the
cut-off point and selection criteria. For example, the
S&P 600 stock index is an index that generally replicates
the performance of the smallest 600 companies in the US.
The median market capitalization of companies that constitute
this index is around $2 billion and accounts for 3% or
so of the total US investable stock market.
c) Growth Stocks
Growth stocks refer to a division of the US investable
stock universe into companies that have characteristics
commonly called “growth” characteristics.
These characteristics may include such important valuations
parameters as price/book ratios, price/earning ratios
or price/sales ratios. Each index varies slightly in the
cut-off point and selection criteria. For example, the
Russell 1000 “Growth” index is an index that
replicates the performance of that half (approximately)
of the 1000 largest companies in the US that have the
highest price-to-book ratios and forecasted growth.
d) Value Stocks
Value stocks refer to a division of the US investable
stock universe into companies that have characteristics
commonly called “value” characteristics. These
characteristics may include such important valuations
parameters as price/book ratios, price/earning ratios
or price/sales ratios. Each index varies slightly in the
cut-off point and selection criteria. For example, the
Russell 1000 “Value” index is an index that
replicates the performance of that half (approximately)
of the 1000 largest companies in the US that have the
lowest price-to-book ratios and forecasted growth.
Note! In portfolio construction (also known as asset allocation
planning) an investor or investment advisor will generally
work with index funds that reflect a combination of the
above-delineated characteristics as follows:
1. Large cap growth (large stocks with growth valuation
characteristics);
2. Large cap value (large stocks with value valuation
characteristics);
3. Small cap growth (small stocks with growth valuation
characteristics);
4. Small cap value (small stocks with value valuation
characteristics);
See proper asset allocation
for a fuller discussion of the use of index funds in the
asset allocation process.
Domestic
Bonds (Fixed Income Instruments)
Investment can be made in an index fund that reflects an
index of nearly the entire US bond market. For example,
the Lehman Brothers Aggregate Bond Index is an index that
mirrors a broad swath of the investable US bond market and
a number of index funds exists that are constructed to reflect
the performance characteristics of this entire US bond market.
For portfolio planning purposes, however, an investor or
investment advisor may wish to emphasize one aspects of
the total US bond market over other elements, that is provide
an investment “tilt” in one direction or another.
The broad asset class “US bonds” is commonly
divided into the following sub-classes:
Division by Maturity Length
a)
Short Term Bonds
Short term
refers to a division of the US investable bond universe
into the bonds with short, intermediate and longer-term
maturities. Short term generally refers to maturities
of 3 years or less.
b) Intermediate Term Bonds
Long term refers to a division of the US investable
bond universe into the bonds with short, intermediate
and longer-term maturities. Short term generally refers
to maturities of 4 years or more but less than 10 years.
c) Long Term Bonds
Long term refers to a division of the US investable
bond universe into the bonds with short, intermediate
and longer-term maturities. Long term generally refers
to maturities of 10 years or more.
Division
by Credit Quality
a) US Government Bonds
US
Government Bonds refers to a division of the US investable
bond universe into the bonds with various degrees of
credit-worthiness. These generally are classified (from
most credit worthy to least) as US Government, Investment
Grade US Corporate and High-Yield US Corporate. US Government
bond index funds invest exclusively in US Treasury securities
and that of various quasi government agency bonds.
b) Investment Grade US Corporate Bonds
Investment Grade US Corporate Bonds refers to a division
of the US investable bond universe into the bonds with
various degrees of credit-worthiness. These generally
are classified (from most credit worthy to least) as
US Government, Investment Grade US Corporate and High-Yield
US Corporate. Investment grade US Corporate Bonds index
funds invest exclusively in the fixed income securities
of US corporations with investment grade or better credit-worthiness
as measured by various valuation characteristics.
c) High-Yield US Corporate Bonds
High-Yield US Corporate Bonds refers to a division of
the US investable bond universe into the bonds with
various degrees of credit-worthiness. These generally
are classified (from most credit worthy to least) as
US Government, Investment Grade US Corporate and High-Yield
US Corporate. High-Yield US Corporate Bonds index funds
invest exclusively in the fixed income securities of
US corporations with the lowest credit-worthiness as
measured by various valuation characteristics.
Note! In portfolio construction (also known as asset
allocation planning) an investor or investment advisor
will generally work with index funds that reflect a
combination of the above-delineated characteristics
as follows:
1. Short Term US Government (short term maturities of
US Government instruments);
2. Intermediate Term US Government (intermediate term
maturities of US Government instruments);
3. Long Term US Government (long term maturities of
US Government instruments);
4. Short Term Investment Grade Corporate (short term
maturities of US corporations with investment grade
or better credit-worthiness);
5. Intermediate Term Investment Grade Corporate (intermediate
term maturities of US corporations with investment grade
or better credit-worthiness);
6. Long Term Investment Grade Corporate (long term maturities
of US corporations with investment grade or better credit-worthiness);
7. Short Term High-Yield Corporate (short term maturities
of US corporations with low credit-worthiness);
8. Intermediate Term High-Yield Corporate (intermediate
term maturities of US corporations with low credit-worthiness);
9. Long Term High-Yield Corporate (Long term maturities
of US corporations with low credit-worthiness);
See proper asset allocation
for a fuller discussion of the use of index funds in
the asset allocation process.
International
Securities
Investment
can be made in an index fund that reflects an index of a
large swath of the investable International stock market
and the investable International bond market. For example,
the Morgan Stanley MCSI EAFE (Europe, Asia and the Far East)
is an index that mirrors a broad swath of the investable
International stock market and a number of index funds exists
that are constructed to reflect the performance characteristics
of this universe of securities.
For portfolio planning purposes, however, an investor or
investment advisor may wish to emphasize one aspect of the
total International securities market over other elements,
that is provide an investment “tilt” in one
direction or another. The broad asset class “International
Securities” is commonly divided into the following
sub-classes:
Division Between International
Developed Markets Stocks, International Emerging Markets
Stocks, and International Bonds as follows:
a) International Developed Markets Stocks
International Developed Markets refers to a division
of the International Securities universe into the three
major sub-categories, two stock categories and one bond
category. The two stock sub-categories are International
developed market stocks and International emerging market
stocks. The third category is International bonds. International
developed market stocks refers to the stocks of countries
with more developed economies.
b) International Emerging Markets Stocks
International Emerging Markets refers to a division
of the International Securities universe into the three
major sub-categories, two stock categories and one bond
category. The two stock sub-categories are International
developed market stocks and International emerging market
stocks. The third category is International bonds. International
emerging market stocks refer to the stocks of countries
with less developed economies.
c)
International Bonds
International Bonds refers to a division of the International
Securities universe into the three major sub-categories,
two stock categories and one bond category. The two stock
sub-categories are International developed market stocks
and International emerging market stocks. The third category
is International bonds. International bonds refer to the
bonds of non-US companies.
See proper asset allocation
for a fuller discussion of the use of index funds in the
asset allocation process.
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