Index funds have experienced explosive growth over the past 10 to 15 years, primarily from institutional investors. In this book, two investment insiders reveal why index funds are the way to go. Throughout the book, the emphasis is on developing a plan, implementing strategies, and gauging performance. Graphs. Online feature.

Walter R. Good, CFA, has managed institutional investments as both a plan sponsor and external investment manager. As a consultant to large institutional investors, he has worked with both private and public retirement funds as well as philanthropic organizations. He has served as managing partner of Capital Market Systems, president of the Mellon Universe Management Group, chairman of the pension investment committee of the Continental Group, Inc., and member of the Investment Advisory Panel for the Pension Benefit Guarantee Corporation. He is a co-author of two recent books: Active Asset Allocation: Gaining Advantage in a Highly Efficient Stock Market and Managing Pension Assets: Pension Finance and Corporate Financial Goals. Good is a member of the Association for Investment Management and Research (AIMR) and holds undergraduate and MBA degrees from the University of Chicago. Roy W. Hermansen, CFA, has been responsible for institutional assets as a plan sponsor, external manager and consultant. He has served as partner of Capital Market Systems, executive vice president of Mellon Universe Management Group, director of portfolio development at Continental Group, Inc., and as a security analyst specializing in technology stocks at a major investment counseling firm. He is a co-author, with Walter Good and Jack R. Meyer, of Active Asset Allocation: Gaining Advantage in a Highly Efficient Stock Market. He is a member of the Association for Investment Management and Research (AIMR). Hermansen holds degrees in electrical engineering and engineering physics from Lehigh University and an MBA from Columbia University.

FOREWORD

xi

(4)

JOHN C. BOGLE

PREFACE

xv

INTRODUCTION: HOW LESS BECOMES MORE

1

(22)

Surging Index Funds

1

(4)

Identifying the Benefits

5

(4)

Using Index Funds as a Tool

9

(2)

Flowering of a New Industry

11

(4)

Individual Indexing

15

(2)

How this Book Is Organized

17

(6)

PART 1. UNDERSTANDING INDEX FUNDS

23

(40)

1. INDEX FUND DESIGN

23

(24)

Which Index?

23

(1)

Differing Index Characteristics

23

(3)

S&P 500 in Perspective

26

(6)

Other Market-Value Weighted Indexes

32

(5)

Appendix 1-1: S&P 500 Index

37

(2)

Appendix 1-2: Wilshire 5000

39

(1)

Appendix 1-3: Russell 2000

40

(1)

Appendix 1-4: S&P MidCap 400 Index

41

(1)

Appendix 1-5: S&P SmallCap 600 Index

42

(2)

Appendix 1-6: Morgan Stanley Capital International (MSCI) Indexes

44

(2)

Appendix 1-7: Lehman Brothers (LB) Aggregate Bond Index

46

(1)

2. TURNING AN INDEX INTO A INDEX FUND

47

(16)

Overview of Index Fund Operations

47

(1)

Indexing for a Large Financial Institution

47

(5)

Mutual Funds: Indexing for Individual Investors

52

(3)

Portfolio Building Blocks

55

(8)

PART 2. ASSESSING THE BENEFITS

63

(70)

3. MEASURING THE COSTS

63

(34)

First of Two Key Issues

63

(5)

Narrowing the Expense Ratio

68

(2)

Assessing Transaction Costs

70

(7)

Pay Now or Pay Later

77

(3)

Tax Savings

80

(4)

Adding Up the Costs

84

(11)

Appendix 3-1: Deferral of Capital Gains Taxes

95

(2)

4. INDEXING THE BOND MARKET

97

(10)

Growing Segment of Fixed Income Market

97

(2)

Index Fund Advantage

99

(8)

5. HOW "DUMB" MISTAKES MAKE "SMART" MARKETS

107

(26)

Assessing the Opportunity

107

(7)

Gauging the Results of Active Investing

114

(4)

Explaining the Paradox

118

(9)

Active Investing in "Smart" Financial Markets

127

(6)

PART 3. INVESTING IN AN UNCERTAIN WORLD

133

(78)

6. DEVELOPING THE PORTFOLIO PLAN

133

(24)

Balancing Risk and Reward

133

(6)

How Much Return?

139

(4)

How Much Risk?

143

(5)

Choosing the Right Portfolio

148

(6)

Appendix 6-1: Underlying Data for Stocks, Bonds, and Bills

154

(1)

Appendix 6-2: Risk Calculation

155

(2)

7. PUTTING INDEX FUNDS TO WORK

157

(34)

Implementing the Marker Portfolio

157

(4)

Diversifying with Index Mutual Funds

161

(10)

Adjusting the Plan

171

(11)

Appendix 7-1: Index Funds Available to the Individual Investor

182

(4)

Appendix 7-2: Index Fund Tracking Error

186

(5)

8. OUTSMARTING THE INDEXES

191

(20)

Departing from the Index Fund Portfolio Plan

191

(1)

Exploring Alternatives

192

(3)

Controlling Risk

195

(10)

Active Investing in an Index Fund Framework

205

(6)

PART 4. RESPONDING TO CHANGE

211

(52)

9. GAUGING PERFORMANCE

211

(16)

Maintaining Perspective

211

(4)

Measuring Total Portfolio Performance

215

(6)

Identifying Sources of Positive and Negative Returns

221

(4)

What to Do about Taxes

225

(2)

10. MAKING IT HAPPEN

227

(26)

How to Get Started

227

(1)

Addressing the Key Decisions

228

(3)

Obstacles that Get in the Way

231

(9)

Appendix 10-1: Weighing Capital Gains Tax Liability against the Index Fund Cost Advantage

240

(11)

Appendix 10-2: Redirection of Dividend Reinvestment

251

(2)

11. WHY INDEXING?

253

(10)

Two Contrasting Points of View

253

(1)

Revisiting the Record of Active Investing

254

(1)

Daunting Challenge

255

(1)

How Index Funds Gain Advantage

255

(1)

Ambitious Standard for Active Investing

256

(1)

How to Make Use of Indexing

256

(1)

"Do's and Don'ts"

256

(2)

Future of Individual Indexing

258

(5)

INDEX

263

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