Have you given up trying to beat the stock market indexes? Are you tired of actively-managed funds that tarnish their sterling performance records as soon as you invest? If so, you might be thinking of putting some or all of your stock investments in index funds. But why settle for only index fund returns? You can do better, with all the benefits of an index fund and maybe a few more advantages.
Instead of buying an index fund, buy an index trust. Also known as unit investment trusts, these trade on the American Stock Exchange or NASDAQ.
Like a fund, an index trust buys the stocks that make up an index. The AMEX trust with the ticker SPY buys all the stocks in the Standard & Poor’s 500 index. Unlike the index funds, the trusts don’t redeem shares from investors. So the trusts don’t have to keep cash on hand or make sales to pay redemptions. Being fully invested all the time, the trusts have a shot at better returns than the funds. (The funds often use futures and options contracts to try to make up for their cash balances; some do it well, some don’t.)
The funds are priced at the end of the day, and you buy or sell shares based on that end-of-day value. The trusts are constantly valued and can be bought any time of the day at the current price. That gives you a lot more liquidity than you get with a fund. With a trust you can buy or sell early in the day and get that price, not the closing price you’d get with a fund, which could be a significantly different price.
The trust also gives you tax advantages. An index fund must distribute its gains and income to shareholders by the end of each year. And index funds have a lot of built-up gains in them. Index funds don’t do a lot of trading, but they do realize some gains each year. When a stock must be sold because it was dropped out of the index, there are capital gains to distribute to investors unless the manager can offset it with a loss. And if more investors redeem shares than put in new money, shares must be sold to pay out cash. This also can result in capital gains to you.
It’s possible that in a market decline or slow down there would be a lot of redemptions from funds. That would trigger stock sales, followed by large capital gains distributions to those who remain with the funds. You could pay taxes on gains that were earned before you invested in the fund.
That’s not the case with trusts. They don’t redeem shares and don’t distribute gains or income to shareholders. There are no capital gains taxes as long as you hold the shares.
There is the potential that shares of the index trusts will sell for less than the value of the underlying stocks they own, because prices are determined by supply and demand for the trust shares. But large pension funds and other institutions like the index trusts, and their presence in the market has kept the shares selling at or very close to the value of the stocks the trusts own.
Index trust expenses are comparable to those of index funds. You’ll pay a commission to buy and sell the trust shares. But over time, the lower annual taxes should more than make up for that.
The graph on page two compares the total return of the Vanguard Index 500 fund to the AMEX S&P 500 trust. So far this year, the fund is slightly ahead of the trust, before considering any taxes or commissions. That gap between the two on the graph is $7.00, less than 1% of the initial investment. A longer-term graph would show some periods when the fund is on top and some when the trust is the better performer. The Vanguard fund usually is the best performing index fund because its fees are so low. The trust is clearly better than most other index funds.
But the real advantage of trusts is that you can build a custom portfolio with trusts in a way that you cannot with index funds. Index funds don’t let you slice and dice the indexes the way you can with trusts.
The most popular choice of indexers is the S&P 500, which you can buy through the S&P 500 Trust on the AMEX (ticker symbol: SPY).
But you can beat the S&P 500 by investing in only its fastest-growing companies and industries, which you can do this with trusts.
The AMEX has created Standard & Poor Depository Receipts, known as Spiders. These separate the S&P 500 stocks into nine industry or sector trusts. You can invest only in the industries you like and ignore the others. You could own a technology index, the S&P Select Technology Sector Trust (XLK). Then you could add other sectors you like, such as financial (XLF), consumer services (XLV) and consumer staples (XLP). You could avoid lower-returning industries such as utilities and cyclicals.
You also might look at other indexes.
The S&P 500 has beaten other broad indexes in recent years because it is dominated by the largest companies, which have had the best returns the last four years. But the S&P 500 is not a truly passive investment. The index is determined by a committee at Standard & Poor’s. The committee made 48 changes in 1998. Some were due to mergers, other changes were made because the committee wanted stocks that it thought would have higher returns in the index.
If you want to own only the hottest stocks, consider the NASDAQ 100 Trust (QQQ). That index contains the fastest-growing stocks on the NASDAQ and has beaten the S&P 500 for several years. It has most of the big technology names (Microsoft, Dell, Intel, MCI WorldCom) and also fast-growers in other industries, such as Starbucks and Bed Bath & Beyond. It does not include financial stocks. It also does not include companies that are not listed on the NASDAQ, such as America Online, IBM, and Hewlett-Packard.
When you want to avoid large company stocks, you can invest in the S&P Midcap 400 Trust (MDY). Is the Dow Jones Industrial Index the one you like? If so, you can buy the Diamonds trust (DIA). Unfortunately, trusts still are not developed to match small company or the total stock market indexes.
The trusts also can be used to invest internationally through World Equity Benchmark Series (WEBS) trusts. There are 17 trusts, each of which seeks to match a country’s stock index. You cannot buy emerging markets through these trusts. But you can buy the major developed countries in Europe and Asia, plus Mexico and Canada. You can concentrate on the country or countries that you believe have the best economic prospects and leave out the others.
The S&P 500 trust has been available for years. But the NASDAQ 100 trust has been available only since March, and the Spiders since the end of 1998. The WEBS are a couple of years old. These investments can be in either a Core or a Managed Portfolio, depending on how you want to use them.
To learn more about these trusts, visit the NASDAQ web site (www.nasdaq-amex.com) and click on the “index-based investments” button at the top.