How to Set Up an Index Fund

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Stock picking has been shown to often underperform the market indexes.
Stock picking has been shown to often underperform the market indexes. (Image: Dynamic Graphics Group/Dynamic Graphics Group/Getty Images)

In 1949, a Princeton student studied the market performance of professional portfolio managers. His studies showed that an index, such the Standard & Poor's 500, made up of the 500 largest U.S. publicly traded companies, would regularly outperform 75 percent of those investment managers. In 1976, Vanguard Investments created and marketed the first index fund, based on the S&P 500, and gained such a large following that professional portfolio managers and mutual funds began cloning the various indexes. Although it is difficult for an individual to accurately clone even a small index, such as the 30 stocks represented by the Dow Jones Industrial Average, many packaged investment products exist that duplicate indexes or market sectors.

Determine the market index you intend to clone. The Dow Jones Industrial Average contains just 30 different stocks. Other indexes are much larger, such as the S&P 100 and 500, and the Russell 2000. Funds duplicating these indexes generally manage their portfolios via automatically generated computer trades.

Figure the percentage each stock or each market sector occupies out of the whole and purchase exact amounts.

Rebalance the contents of your portfolio daily to have a true clone of your chosen index, because this percentage will change as the market reacts to economic events.

Consider buying only the stocks with the largest market share representations in each index, or each industry sector represented in the index. Because of the weighting used in the composition of certain indexes, performance of these few companies overwhelms the performance of all the others contained in the index.

Consider the cost of managing your index portfolio relative to investing in a mutual fund index fund. Generally, there is little or no stock picking involved in these funds, so unless you intend to edit the composition of the indexes with your own selections, you are unlikely to perform better than a packaged fund.

Tips & Warnings

  • You can buy mutual funds, unit investment trusts (UIT) and exchange traded funds (ETF) that clone the various indexes. You can also set up your fund to represent key sectors of the market using these packaged products.
  • Professionally managed index funds outperform the stock-picking portfolio managers because they represent total market direction. They are unwieldy to rebalance and experts suspect that they influence the market direction merely because of the huge size of their investments.

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