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Hello everyone and welcome to another episode of EricksonTV, Curtis here with Lauren. For
those of you who haven't seen our last episode, we talked a bit about Eugene Fama winning
a Nobel Prize in Economics. Mr. Fama has done many studies on index funds. Without going
into the why's and the what's. Lauren, can you, in laymen's terms, explain what an index
fund is? An index fund is basically just taking a snapshot of the market and you get exactly
what is in the market. So when they talk about the S&P 500 index fund, what is that? The
S&P stands for Standard and Poor's but what's important is the 500. The S&P 500 index is
the 500 largest US companies. So if you buy that index fund you get the 500 biggest companies.
And the proportion of each stock in the fund is exactly equal to its proportion in the
general market.
How does that contrast to an active fund? Even though there's been a much larger increase
in the percentage of investors using index funds, there's still a predominance of people
using active fund managers. There seem to be more and more active fund managers the
less popular active funds get. Their declining popularity is pretty simple. An active fund
manager is attempting to basically do better than indexes by picking the correct stocks
or by timing the market, moving in and out of the stock market at the correct times.
There's a real simple difference: generally the turnover of the stocks are much higher
in an active fund than in an index fund because they are trying anything to beat the indexes.
And if an index fund is doing its job correctly it will generally mirror the index's average
less the expense. Day to day, and certainly month to month, it moves along right with
the actual index.
Now to finish off this series, we recently had did a seminar where we had some great
questions from clients. One of the questions was, "Because indexes do change the components
of an index in a given year, what does that do to the portfolio, for taxes, for trading
costs, etc.?" This is a tough question because the person wanted to know, if we use passive
management, how do we reduce these trading costs when indexes reconstitute? Briefly,
we don't use strict index funds we use structured passive funds. Here's an example: when we
have a fund that invests in small company stocks, let's say there's an imaginary line,
where under the line lie the 20% smallest companies and above the line lie the 25% smallest.
A stock might move in and out of this index. The funds buy it when it's beneath 20% and
they don't sell it until it goes above 25%. So it prevents you from buying and selling
as the stock gets a little bit bigger and a little bit smaller. There's some wiggle
room and that reduces trading costs. So the funds we use don't exactly mirror indexes.
This is just one example, but the funds do many things to reduce trading costs as much
as possible.
And because they are not strictly tied to that index there is a thought that if, let's
say, every index fund out there know that XYZ company is being dropped from the index,
that would be the absolute worst time to have to sell it because everyone would be selling
it at the same time. So the advantage for our structured funds is we can wait. Maybe
we won't even sell XYZ fund or we wait until after the turmoil has subsided. That was a
great question from our client. But I want to be really clear that even with the changes
in the indexes, the amount of turnover in our portfolios is significantly less than
the typical active fund. In fact it's lower than the average index fund. Well thank you
very much for watching this episode of EricksonTV. We'll see you next time.