The Complete Guide to Investing in Index Funds How to Earn High Rates of Return Safely

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The Complete Guide to Investing in Inde

Index funds are rapidly growing in popularity; this has been a long-kept secret of financial insiders.

Index funds are a collective investment tool used to track the stock market index’s performance. An investor can buy shares comprising the index or buy a sample of shares that make up the index. A fund’s value is linked to the index; if the index rises, the value of the fund also rises. Index funds outperform 80 percent of How to Earn High Rates of Return Safely

managed funds. This reduces the anxiety and expense of trying to beat the market and predict what stocks, bonds, or mutual funds will perform well. It is no wonder insiders have kept this market strategy such a secret.

The Complete Guide to Investing in Index Funds will teach you about the different indexing methods, including traditional, synthetic, and enhanced indexing. You will learn about the many advantages of index funds — low costs, simplicity, and lower turnovers. You will read about diversification, asset allocation, capital gains tax, enhanced index funds, and the common mistakes investors make with index

funds.

By

You will also learn how to achieve balance, how individual funds perform, how to use Craig W. Baird

exchange traded funds for effective asset allocation, how to choose the right fund, how to develop a portfolio, and much more.

Whether you are a first-time investor or a x Funds —

stock market pro, you will discover valuable information about how index funds work, what factors to consider before investing, and how to avoid common pitfalls. By reading The Complete Guide to Investing in Index Funds, you will ultimately learn how to maximize your return while minimizing your risk.

With Foreword By Alvin Boutte Jr.

Atlantic Publishing Group, Inc.

Managing Director, Midwest Region

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The Complete Guide to

Investing in Index Funds —

How to Earn High Rates of Return Safely

By Craig Baird

The CompleTe Guide To invesTinG in index Funds: how To earn hiGh raTes oF reTurn saFely

Copyright © 2009 by Atlantic Publishing Group, Inc.

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ISBN-13: 978-1-60138-205-4

ISBN-10: 1-60138-205-7

Library of Congress Cataloging-in-Publication Data Baird, Craig W., 1980-The complete guide to investing in index funds : how to earn high rates of return safely / by Craig W. Baird.

p. cm.

Includes bibliographical references and indexes.

ISBN-13: 978-1-60138-205-4 (alk. paper)

ISBN-10: 1-60138-205-7 (alk. paper)

1. Index mutual funds. I. Title.

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Dedication

To Layla, for allowing me to follow a new path.

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Table of Contents

Table of Contents

5

Foreword

13

Preface

17

What Is an Index Fund?

25

An Index Fund, You Say? ............................................27

What Is Benchmarking? ..............................................28

The Dow Jones Industrial Average ..............................29

The S&P 500 ...............................................................31

Other Indexes .............................................................32

Bond Market Indexes ..................................................32

Mortgage-Backed Securities ........................................35

Passive Investment Management and Bond Indexes ... 35

Bond Indexes ..............................................................35

Stock Markets vs. Stock Indexes .................................36

The Usefulness of the Indexes ....................................38

What is a Mutual Fund? .............................................40

Types of Mutual Funds ...............................................41

Why Have Mutual Funds? ...........................................44

Mutual Funds Beget Index Funds .............................. 45

Myths of Index Funds .................................................46

The Types of Indexing ................................................ 46

Diversification ............................................................ 52

Asset Allocation ......................................................... 54

Who is an Active Investor? ......................................... 56

Who is an Index Fund Investor? ................................. 58

What Would You Do? ................................................. 60

Now You Know ........................................................... 63

The History of the Index Fund

65

Chevalier de Mere ......................................................66

Louis Bachelier ..........................................................67

Harry Markowitz ........................................................72

James Tobin ...............................................................75

William Sharpe ...........................................................76

Eugene Fama ..............................................................77

Michael Jensen ...........................................................80

The Foundation Is Set .................................................81

Efficient Market Hypothesis ........................................81

The First Index Fund ..................................................82

John Bogle ................................................................ 86

Burton G. Malkiel .......................................................89

David Booth ................................................................91

Dimensional Fund Advisors ........................................91

The University of Chicago ...........................................92

A Long and Winding Road ...........................................93

Why Index FundsAre the Way to Go

95

Advantages of Using Index Funds .............................. 96

Index Funds: Like a Mutual Fund, Only Better .......... 99

The Folly of Active Investors ....................................... 99

The Folly of Stock Pickers ...........................................100

The Folly of Time Pickers .......................................... 102

The Folly of Manager Pickers..................................... 104

The Silent Partners of Other Investments ...................106

So are Index Funds the Way to Go? ...........................108

U.S. Equity Index Funds

113

Market Capitalization .................................................114

Large-Cap Fund .........................................................115

Mid-Cap Fund ...........................................................115

Small-Cap Fund ........................................................116

Micro-Cap Funds .......................................................116

The Index Providers ...................................................117

Sector Index Funds ....................................................131

Classifying Industry Sectors .......................................131

The Global Industry Classification Standard .............. 132

Industry Classification Benchmark ............................134

Merrill Lynch HOLDRS .............................................. 134

Real Estate Investment Trust Index Funds ................. 135

Investing in Real Estate Investment Trusts ................ 137

Indexes for the Socially-Responsible ......................... 139

Alternative U.S. Equity Funds ................................... 140

Equal-Weight Funds ................................................. 141

What is a Dividend? .................................................. 142

Dividend-Weighted Funds ......................................... 144

So many indexes….................................................... 147

Global & International Equity

149

Understanding International Investing ...................... 150

Developed Market Indexes and Funds ....................... 151

Emerging Market Indexes and Funds ........................ 154

BRIMC ...................................................................... 157

Regional Index Funds ............................................... 159

Global Market Indexes and Funds ............................. 161

Country Index Funds ................................................163

A World of Indexes .................................................... 164

Commodity & Currency Funds

167

What Are Commodities? ............................................ 168

Commodity Trade ..................................................... 169

Another Type of Index? .............................................170

Futures .................................................................... 170

Individual Commodities ............................................ 171

Commodities Indexes ................................................ 173

Total Return Indexes ................................................. 178

Total Return Commodity Funds ................................ 178

Currency Funds ........................................................ 178

Currency-based Indexes ........................................... 181

Where Do We Go from Here? ..................................... 181

Planning & Setting Goals

189

Risk .......................................................................... 190

The Three Factor Risk Model ..................................... 191

Understanding Risk Tolerance and Avoidance ........... 194

All About Control ...................................................... 196

Where to Begin ......................................................... 198

The Goals ................................................................. 199

Investment Return .................................................... 200

Projecting Index Fund Returns .................................. 201

Selecting the Portfolio through Asset Allocation .........204

Aggressive Allocation ................................................205

Conservative Allocation .............................................206

Moving On ............................................................... 207

Putting Together a Portfolio

209

Stocks or Bonds? .................................................... 210

Life’s Little Stages ................................................... 210

Taxes ....................................................................... 214

All About Planning and Maintaining ......................... 219

Managing YourIndex Fund Investment

221

Opening an Index Fund Account .............................. 222

Paperwork ............................................................... 224

Procrastination ....................................................... 226

Advisors................................................................... 226

All There Is To It ...................................................... 229

The End is a New Beginning..................................... 229

Low-Cost Index FundProvider Profiles 233

Barclays Global Investors......................................... 233

Bridgeway Funds ..................................................... 235

Dreyfus .................................................................... 235

Fidelity Group .......................................................... 236

First Trust ............................................................... 237

Rydex|SGI ............................................................... 238

Schwab Funds ......................................................... 238

State Street Global Advisors ..................................... 240

T. Rowe Price ........................................................... 241

Vanguard Group ...................................................... 242

Case Studies

245

Bibliography

269

Author Biography

271

Glossary

273

Index

281

Foreword

Because I am an investment banker and a former market maker at the Chicago Board Options Exchange (CBOE) and Chicago Stock Exchange, friends and family inevitably ask me for the latest tip or some sort of silver bullet in making sound, long-term investment decisions, and as much as I would like to reveal surprising or profound thoughts on this, the fact is that it is as simple as having a basic understanding of the stock market. However, that takes time in our busy lives, and we often need a quick, easy-to-understand outline to get us started. Fortunately, author Craig Baird has some great advice and provides a comprehensive overview for one of the foundations in sound investment: index funds.

It never ceases to astonish me how much people are willing to risk in the market during a strong economy and how much people hesitate in a weak one. The stock market, especially for short-term investors, is often volatile, and many people are hesitant to invest and find it difficult to pull the trigger.

When the economy is good, those individuals not heavily invested in stocks are thought of as social outcasts. How

14

The Complete Guide to Investing in Index Funds could you possibly sit out and miss these huge returns that everyone else is realizing? Back in the 1990s, it seemed like you could pick stocks by throwing darts and see double-digit returns.

And when things change for the worse, as they sometimes do, those investors who kept the diverse, cautious portfolios become the new experts. They may have missed some large returns, but they also missed some large losses. Everyone seems to be more anxious over the downturns than the upswings.

In today’s world of hedge funds, credit swaps, and private equity funds, how can anyone possibly make sense of the infinite number of investment opportunities? While The Complete Guide to Investing in Index Funds – How to Earn High Rates of Return Safely does not explain the most recent, get-rich-quick scheme or identify the best-kept secret about investing, it does help you plan for a financially secure future. When looking forward to the future, even as far as retirement, understanding and utilizing index funds is a necessity.

Preparing for the unpredictable future is always a daunting task, and trying to accommodate for your retirement is even more complex. But Baird wonderfully describes steps that can be taken today to ensure financial security tomorrow.

As I always tell the clients I am advising, capital markets are a great way to raise funds or jumpstart a project, but these markets are becoming increasingly more complex.

There is much to gain, but also much risk, so it is crucial to understand exactly what is happening. Being able to

Foreword

15

look at your investment strategy and defend every option you choose may be difficult at times, but it is the best way to prepare for the future.

While the economy has and will continually fluctuate between good and bad, your long-term investment objective does not need to. If you understand index funds and use that knowledge while making investment decisions, you will be on your way to a strong and financially secure future. This book

and the ideas outlined within it could

not be more timely or important for

investors during any economic cycle.

Alvin Boutte, Jr.

Managing Director, Midwest Region

Grigsby & Associates

Alvin Boutte, Jr. is the managing director of the Midwest Region for Grigsby & Associates, the nation’s oldest, 100-percent minority-owned, full-service investment banking firm. An expert in investment banking and municipal finance, Boutte’s distinctive background provides comprehensive financial services for a diverse base of clients.

Boutte’s early interest in finance began under his father’s tutelage, Alvin Boutte, Sr., from whom he learned to build and manage one of the most prominent and largest African American-owned financial institutions in the United States –

Independence Bank of Chicago and Drexel National Bank (Indecorp).

16

The Complete Guide to Investing in Index Funds The sale of Indecorp in 1995 provided Boutte an opportunity to move to the brokerage firm of Oppenheimer & Co., where he quickly established himself in emerging market business development and equity arbitrage. During this time, Boutte also became a member of the Chicago Board Options Exchange, Chicago Mercantile Exchange and the Chicago Stock Exchange, where he specialized in arbitrage activities.

Boutte later became partner in a local boutique investment bank and eventually cofounded DuSable Partners, where he developed a business that underwrites municipal bonds and increased exposure within the local pension plan community.

In addition to his work at Grigsby & Associates, Boutte is a board appointee of Chicago Mayor Richard M. Daley for the Illinois Sports Facility Board, the group that owns and operates U.S. Cellular Field. He also serves on the board of directors for the Mercy Home for Boys and Girls. Boutte is a graduate of Bradley University, with post-graduate studies at the University of Chicago.

About Grigsby & Associates

Grigsby & Associates is the second-oldest investment banking firm based in California. Since the firm’s establishment as a corporation by Calvin Grigsby in 1981, Grigsby & Associates has helped local governments to raise more than $400 billion in tax-exempt capital for basic infrastructure, utility, housing, education, transportation, redevelopment, and general funding needs. In addition, the firm has helped arrange $10 billion in public and private corporate offerings.

Preface

There is a common misconception among passive observers of the stock market that what we see now has always been the norm, and little has changed over time since the first stock market was created. This is far from the case. The stock market constantly evolves, as do the economics and finances that drive it.

Early