A breakdown of how index funds are formed

As we learned in our introductory “Indexes and Your Investments” blog post, index funds are groups of stocks, similar to mutual funds, containing stocks with similar characteristics, such as size, geographic location or profit value. Indexes were originally designed to track particular market segments, and they continue to serve as useful benchmarks for how a particular market segment is faring. For the practical, long-term investor, investing in index funds is also a steady, low-cost investment strategy that earns market returns over time. In this blog post, we break down the inner working of index funds, from how they are structured to how indexes compare to one another.

What makes one index more popular than another?

There are hundreds, if not thousands, of stock market indexes that benchmark everything from individual countries and regions to industry sectors and companies of a specific size. Certain indexes are widely popular, while others are lesser known. So, what makes one index more prominent than another?

The popularity of certain indexes over others is primarily driven by popular appeal. Just like competitive market forces, indexes too are subject to the natural order of things. Sometimes, the “best index wins”, while other times it may not.  In short, what makes one index more widely accepted as a benchmark than another is partially arbitrary.

How are indexes structured?

Two of the most prominent U.S. indexes, the Dow Jones Industrial Average and S&P 500, track the same market segment, the U.S. stock market, but the calculations each index uses differ. The Dow uses a price-weighted average of the 30 leading U.S. companies across various industries, while the S&P 500 takes the market value-weighted average of 500 large, reputable U.S. companies.

How the top companies within each index are chosen also differs. S&P 500 companies are selected by a board that uses a fixed set of criteria including companies with:

• Market cap of more than $5.3 billion
• Four consecutive quarters of positive earnings
• Adequate liquidity
• Public float (total number of shares available for trading) of at least 50%

The Dow’s Average Committee also has its own proprietary set of criteria it uses to select the top 30 companies; however, rules for the stocks’ inclusion in the Dow are a bit broader and the composition of the Dow’s top 30 companies rarely changes.

Indexes may be approximate and arbitrary, but useful nonetheless

Because of the differences in how indexes are calculated, indexes are not hard and fast barometers of how markets are faring. Instead, they are approximations of actual market performance. Despite the fact that indexes can contain flaws, they serve as simple, convenient financial models to measure slices of capital markets.
According to Nobel Laureate Eugene Fama, “No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?”.  

The Dow Jones Industrial Average reached 20,000 in January, and at the time of this writing, it is well on its way toward 21,000. What does an index really represent, and what does it mean to you as an investor? We will be tackling these questions over the next few blog posts in a multi-part series devoted to market indexes and the index funds that track them.

What’s an index?

Indexes are a combination of securities that track a particular market segment. An index is considered a representative sample of a market, so when an index does well on any given day, it’s a good bet that the market itself—and other stocks in that market—are doing well, too.

Types of index providers:

The Dow is a stock market index composed of 30 large, publicly owned U.S. companies. In addition to the Dow, which is one of the oldest and most well known indexes, there’s the Standard & Poor’s 500 index, which includes 500 U.S. companies across a multitude of industries, and the Nasdaq Composite, which is an index of all the stocks listed on the Nasdaq stock market.

There’s also the Russell 2000, an index of 2,000 small-cap companies, and the Wilshire 5000, which encompasses every publicly traded U.S. company. And those are just the most popular indexes in the U.S.

Elsewhere, there’s the Nikkei 225 (Japan), ASX 200 (Australia) and the FTSE 100 (U.K.), to name a few.

Why we use indexes

It would be challenging to track individual stocks on a daily basis. There are around 4,000 of them traded in the New York Stock Exchange and Nasdaq, and another 15,000 U.S. stocks trading on smaller markets. That’s why we use indexes, which help reduce all the unmanageable specifics into an easy-to-understand glimpse of current market conditions. Indexes do not, however, perfectly replicate the market it’s meant to represent.

Historically, indexes were created as benchmarks to shed light on how a market segment and the economy driving it was faring. Indexes also allow investors to see how their own investments compared to that market.

These days, investors continue to use indexes as a benchmark for their investments, but they can also ride the market by investing in an index fund. These publicly available index funds are essentially mutual funds designed to track an index, offering broader market exposure and lower fees to investors.

In 1976, John Bogle launched the Vanguard 500 Index Fund, the first publicly available index fund. Bogle’s underlying concept was the idea that time, money and energy was being wasted by investors and fund managers attempting to beat the market, so why not simply earn returns on the market’s natural gains over the long-term with lower management fees?

How not to use indexes

Index milestones, such as the Dow surpassing 20,000, are not indicative of whether it is a good or bad time to buy, hold or sell investments. Many investors make the mistake that these milestones are a sign to sell, but what an index is doing on any given day or month should not interfere with a well-planned investment strategy. Indexes are a great way to build a low-cost, diversified portfolio with steady gains over the long run, but counting on market timing or arbitrary milestones can detract you from your ability to build wealth as a disciplined long-term investor

Be on the lookout for more insight as we dive deeper into indexes. In future posts, we’ll talk more about index funds and their place in a long-term wealth management strategy.

President Trump and his administration have proposed several changes to tax law, including reductions to income tax, capital gains tax (for some tax brackets), and business taxes. Amidst these impending tax law changes, it is important to adapt your investment strategy accordingly.

What changes are in store?

President Trump’s tax plan proposes the following changes:

• A lower marginal income tax rate

• Removal of the 3.8% investment income tax

• Lowering the effective tax for long-term capital gains from 23.8% to 20% for taxpayers in the top tax brackets

Despite taxes lowering for most Americans, tax efficient strategies will continue to play an important role in investors’ portfolios. Historically, even over periods when tax rates were lower, tax-managed equity strategies remained an important tool in one’s investment portfolio.

Take advantage of market volatility and lower tax rates to refine your portfolio

Capitalize on market dips: Tax-managed accounts typically benefit in markets with lower returns and higher volatility. With change being a fundamental talking point in Trump’s campaign, uncertainty and market volatility may be in store. A short-lived market dip may be advantageous if a tax loss-harvesting strategy is used.

Restructure your portfolio: Also, with lower capital gains tax rates for higher tax brackets, there may be opportunities to recalibrate your portfolio in order to benefit your long-term investment strategy.  For example, investors with high concentrations of a single stock or asset class can take advantage of lower tax rates to diversify their portfolio at a lower cost. Similarly, investors holding appreciated securities that no longer support their overall plan can take advantage of the lower tax cost to transition to more appropriate investments. There are several financial calculations your financial advisor can help you with to determine the cost-benefit of such a transition.

Customize your picks: Lower tax rates on stock market gains may also provide you with the opportunity to align your portfolio with your values. The rapid advancements in Environmental, Social & Governance (ESG) investing has delivered a number of new investment vehicles for folks who are so inclined.

Impending changes in tax law and the market environment as a whole provides investors with a perfect window to reevaluate and reassess their long-term investment plan by taking advantage of short-term shifts. If you are unsure about how these new tax law and market changes will affect you, work with your financial advisor to reset your goals, recalibrate your portfolio, if needed, and align your investments to meet your values or interests.

Divorcees should keep an eye on newly revised rules that now apply to Social Security benefit claims. In November 2015, Congress passed the Bipartisan Budget Act, which added a new set of rules for divorced individuals who meet certain criteria.

Key Claiming Strategy that Most People Miss:

A divorcee who is currently single, but was previously married for at least 10 years is qualified to collect on an ex-spouse’s Social Security benefits – even if the ex-spouse has since remarried. If both individuals are at least 62 years old and have been divorced for at least two years, the ex-spouse is independently entitled to claim Social Security benefits on a former spouse’s earnings record, even if his or her ex has not yet started to claim benefits. Furthermore, ex-spouses born ON or BEFORE Jan 1, 1954, are permitted to collect on their ex’s benefits, while leaving their own benefits untapped and left to grow until they reach the age of 70.

In order to claim an ex-spouse’s benefits, while leaving your own intact, you must file a restricted claim for spousal benefits. Filing a restricted application tells the Social Security Administration that you are not applying for all of the social security benefits you are eligible for at the same time.  

New Rules Limit Restricted Claims to Those Born Before 1954

The new Social Security benefits rules, which were signed into law on Nov. 2, 2015, limit restricted claim applications to only those who were born on or before Jan. 1, 1954. In addition to being of full retirement age and born before 1954, the applicant must also not have begun claiming their own Social Security benefits to comply.

Anyone born on Jan. 2, 1954 or later is not permitted to file restricted claims for spousal benefits, meaning that when they file for a spouse or ex-spouse’s benefits, they are filing for all of the benefits they are entitled to, including their own.

Exceptions to the New Rules

There are generally two exceptions to these new rules.

One exception to this age limitation is for widows and widowers, who are permitted to file restricted applications at any claiming age. Widows and widowers may file a restricted application regardless of when they were born and even if they have not yet reached full retirement age.

Another limited exception to this new rule is for claimants caring for a child under the age of 16 or a for a disabled child of any age. In some cases, those who are eligible for a dependent child’s benefits may also be able to file a restricted claim on a spouse’s or ex-spouse’s benefits at any age.

Additional Resources

Full details about restricting your scope of benefits can be found at the Social Security Administration’s website in its Program Operations Manual System. The Social Security Administration also has a useful Social Security calculator that may also help shed some light on the best claiming strategy for you; however, it is best to also consult with a financial advisor to ensure you are factoring in all earnings and liabilities in the equation.
Social Security benefits claims and the rules surrounding them can be complex and may impact your financial planning strategy, particularly as it relates to retirement. Whether you are divorced, widowed, caring for a dependent child, or simply aren’t sure about which Social Security claims benefit strategy is best for you, contact your financial advisor to determine the best Social Security approach for you and your family.

Many people draft an estate plan when they start a family, then do little to make updates to it as other key life events happen. This is a major mistake that can put your hard-earned money built over a lifetime in the wrong hands or tied up for years. To make sure that this doesn’t happen to you, here are ten triggers that should get you thinking about updating your estate plan pronto.

Marriage

Marriage is an important life event that brings another loved one under your care. Estate planning after a marriage doesn’t have to be complex and can simply include updating your beneficiary information, buying a life insurance policy, and updating your emergency contact information. As your marriage progresses, you may also want to consider setting up a will and living will. Your spouse should also play an important role in discussions about how you wish your estate to be managed depending on different scenarios.

Divorce

No one ever plans for divorce to happen to them, yet many people unfortunately go through this process. For some partners, the complexities and emotional toll can be overwhelming. In the midst of just trying to get the whole thing behind them, mistakes can be made. This has resulted in ex’s receiving houses, money, life insurance proceeds and more just because of some estate planning oversight where a will wasn’t updated. Make sure that you make changes to your estate as soon as divorce proceedings have been finalized.

Death

The death of someone who is contained in your will is another often-overlooked event that you need to consider in your estate plan. These important people may be ones who are named as guardians to your children, have inheritance allocated for them, be named as an executor of your estate, or listed as beneficiaries or emergency contacts. While the passing of someone close to you is devastating, it’s important to start transitioning new people to fill the role of the loved one who recently passed as soon as you can. This will help to prevent any lapse should something occur to you during this short window of time. Worse, you may just eventually forget to do it at all!

Changes to Laws

If you move to another state, you should have your will and living will examined. It is possible that some of the language might not be applicable to the laws in the state where you now reside. One of the biggest changes in laws that can dramatically affect estate plans are changes to the tax laws. When the IRS or your state change the amount of the estate tax and the thresholds surrounding who will be taxed, it’s time to look at your estate plan again. It may require you to change how money is distributed to minimize tax burdens for your heirs. It also may change your strategy completely, for better or for worse. Make sure to seek advice from your financial advisor, attorney and accountant for help in making these decisions.

Hitting the Jackpot

As a result of hard work or simple luck such as being a lottery winner, you may find yourself in a very secure financial position.   This may lead to becoming the owner of pricey new items, such as cars, yachts, homes and businesses. If you find yourself in this situation, examine your estate plan in more detail. Estates with more assets carry a higher tax burden and can lead to more infighting about who gets what assets among the family members. To avoid these situations, it may be wise to set up a Trust with ironclad language so that it will be harder for people to manipulate other family members into doing something they’ll regret. Then, make sure to share your will and discuss it with those people who will inherit your assets or play an important role in managing your estate after you’re gone. This single tip has proven to be the most productive part of the estate planning process and helps ensure everyone understands your wishes while minimizing surprises.

Purchasing or Refinancing a Home

Anytime you purchase or acquire a new asset, such as a home or other real estate, make sure that the legal owner of that asset is your trust. Sometimes people forget to do this or lenders will take the property out of your trust during a refinance, which makes these assets go through the public probate courts. If your properties are not in your trust, work with your estate-planning attorney to help transfer the properties to the trust.

Opening New Accounts

To avoid probate and make sure the transfer of your title to beneficiaries goes smoothly, make sure all savings accounts, mutual fund accounts, brokerage accounts, life insurance policies and checking accounts are also in the trust. While it is not often intuitive, consider opening large bank accounts, such as those opened after acquiring an inheritance, in the name of the Trust right from the beginning to avoid any unnecessary complexities for your heirs.

In addition to new accounts, here are some other commonly overlooked items that you may want to title to your trust:

• Bank accounts
• Brokerage accounts
• Life insurance policies
• Businesses
• Cars, boats and planes
• Collectibles and antiques

Family Additions

Adding another member to the family is one of the most exciting times in life, but it’s not an excuse to forget to update your estate plan. Having a child requires major revisions to your estate plan, not only in who will inherit your estate but also who will fill the role of executor in the future. Of course, over the course of time, these elements will also change as your children grow up and mature.

Major Health Changes

Unfortunately, some people will face a major health crisis and have no estate plan in order. Whether it’s a cancer diagnosis or another chronic illness, there’s no point in stalling any longer. Make sure that your estate is in order and especially make sure that you have an Advanced Directive form on file. You may also want to talk to your doctors and attorneys about completing DNR and POLST forms if they are available in your state. That way you can make sure that you get the exact medical treatment you want and not what someone else thinks is best for you.

Changes to Your Business

If your ownership interest changes in a business, if partnership interests change, or if a business is purchased or sold, you need to see what impact it has on your estate plan. You may want to consider creating a business succession plan or asset distribution plan in the event you decide to sell your business. There may also be tax implications that can impact your heirs without proper planning in advance.

The passage of time is reason enough to take a periodic look at your estate plan to make sure everything is up to date. At a minimum, you should set a reminder to review your estate plan every 3-5 years, even if there have been no changes. Sometimes you’ll notice something that needs to be changed or remember that you forgot something once you look it over again.

Since the release of the Department of Labor’s new fiduciary rule and following many reports about the failure of most active fund managers in outperforming their benchmarks, there has been a lot of talk lately about a massive shift from active management to passive products.

According to a recent press release from Broadridge Financial Solutions, Inc., there has already been a big shift from actively managed mutual fund accounts to passively managed ETF products in 2016.  

“During the first half of 2016, net new assets for passively managed mutual funds increased by $37 billion, or 14 percent, for the retail distribution channels, while actively managed funds were down by $24 billion, or 0.6 percent,” said Frank Polefrone, senior vice president of Broadridge’s data and analytics business in the press release. “With pending regulatory changes related to appropriate share class usage and the Department of Labor’s new fiduciary rule, we expect the growing use of passively managed funds by advisors, along with the increasing popularity of ETFs to continue to accelerate.”

Despite all the hype, longtime mutual fund manager Bill Miller who was best known for beating the S&P for 15 years in a row says that the shift may not be as radical as it seems. In fact, he suggests that many active fund managers are simply closet index fund managers with a higher price tag.

In a recent Bloomberg Radio podcast hosted by columnist Barry Ritholtz, Miller theorizes that most, about 70 percent, of active fund managers invest in many of the same stocks as the benchmarks they are trying to mimic or outperform, effectively creating a higher-priced index fund. The reason for this lack of deviation, he says, is due to limitations that are explicitly stated rules of a company – such as constraints on how much overweight or underweight managers can be in the various components of their benchmark – as well as preservation tactics that are inherent to one’s human nature.

Active managers with portfolios that vary drastically from their benchmarks – for example, those heavily weighted in one sector – obviously carry a much higher intrinsic risk due to the lack of diversity and hedges. On the one hand, that high-risk, high-reward model is necessary for active fund managers to outperform their benchmark and compensate for their higher fees. On the other hand, they are putting both their portfolios and their jobs on the line. In the end, most active fund managers opt to stick closely to their benchmarks.

Investors using active fund managers that are really just closet indexers wind up paying a higher price for the same outcome or worse, and those using active fund managers that deviate drastically from their benchmarks may be putting their savings on the line.

Miller shows that not only is passive fund management a cheaper alternative for the millions of buy-and-hold investors, but it is also the investment management strategy of choice for many sophisticated traders and active fund managers as well. The so-called “active to passive” shift, he says, is really a shift from expensive passive investing to cheaper passive investing.

Let’s face it, none of us ever go into an investment thinking it will not work out, but this does occur and can end up resulting in a loss.  In these cases, we can use these losses to our advantage for tax planning purposes. Tax-loss harvesting is a powerful tool you can employ to convert losses into tax savings without diverting drastically from your long-term investment strategy or outcome.

Here’s how the strategy works:

First, make sure to consult with your financial advisor or accountant before making any decision based on what you learn here. Tax harvesting can be complex and change over time as tax laws change. Your financial professionals will have the best insight into current laws and practices.

Currently, investors can use unlimited losses to offset capital gains, but only claim up to $3,000 per year in losses against normal income.  However, any unused losses can be carried forward to use in future year.  For example, if you have a $9,000 loss, you can take a $3,000 deduction each year for three years. It’s important to understand that you won’t get the full $9,000 loss claim in one year unless you also have $9,000 in gains. Knowing this can help you offset other gains and income.

Doing this correctly is a 3-step process to ensure you are correctly following IRS guidelines:

1. Sell your shares for a loss.
2. Reinvest in a similar, but not identical position.
3. Reinvest in the original position at least 31 days later.

This is a powerful strategy to help you reduce your effective tax rate and increase your net worth. When used properly, tax harvesting can make significant improvements to your investment portfolio over long periods of time.  This works particularly well with index or passive mutual funds.  You can sell a fund that is linked to an specific index and at the same time buy another funds that is linked to a similar but not identical index.

However, there are some instances when it doesn’t make sense to implement this strategy:

• If you plan on waiting 31 days to repurchase the original investment, it can be dangerous to utilize this strategy because of the dramatic market ups and downs that are present in these types of markets. It can be hard to time the trade exactly right and you may find that your loss turned back to break even in only one week’s time.  
• Another poor implementation of this strategy is to use it when the trading costs don’t outweigh the tax savings. Remember that there are at least four trades involved here, each with a commission or a fee. When the tax savings will be minimal or equal to the total combined trading fees, it just doesn’t make sense to follow this model.
• This strategy only works in your personal investment accounts and cannot be used in any retirement accounts such as a 401(k), IRA or Roth IRA.

Taking a loss is never in the initial purchase plan and none of us like being in a investment that is currently down.  However, knowing that there is a tax strategy that can help you save money on your taxes is very helpful to  continue steady growth and remain secure in your wealth management strategy into the future. If you are concerned about losses in your portfolio, contact your financial advisor to determine if tax-loss harvesting is an option for you.

Many people think it makes sense to invest in shares of the company that they work for. Intuitively, it makes sense, since as a full time employee, you have a better grasp on the growth of the company and will be updated daily on its growth, new products and other important information. In fact, many companies offer special employee stock purchase plans where employees are able to buy shares at a discounted rate compared to the market price. This can make it extremely tempting, and many employees do purchase enormous amounts of stock in shares of the company that employs them for both their retirement accounts and personal accounts. But is this actually a good idea?

The percentage of companies offering employer stock as an investment option in a 401(k) has decreased in recent years but is still significant. According to human capital consulting firm Aon Hewitt, for all companies –public and private – the percentage offering employer stock was 34% last year, down 5% from 2013. However, among companies with publicly traded stock, the percentage is a whopping 63%.

Unfortunately, employees of Wells Fargo took the bait and loaded up on shares of their company’s stock. A recent investigation revealed that the company knew that its stock price was bloated and yet still did nothing to warn employees to reduce their share purchases. In the aftermath of the recent fraud case against the company, Wells Fargo’s stock price has plummeted 12%. This has left many investors in the red. For employees who own substantial amounts of shares, the losses are even more significant.  Wells Fargo is not alone; similar proposed class action lawsuits have also been brought by employees of Whole Foods, BP, and RadioShack to name a few.

Think about what would happen to you and your family if you worked for Enron and decided to put all of your retirement savings into shares of Enron stock. Here is an excerpt from a New York Times article dated 2001:

The rapid decline of the Enron Corporation has devastated its employees’ retirement plan, which was heavy with company stock, and has infuriated workers, who were prohibited from changing their investments as the stock plunged.

Through the 401(k) retirement plan, employees chose to put much of their savings in Enron shares, and the company made contributions in company stock as well. But around the time Enron disclosed serious financial problems last month, the company froze the assets in the plan because of an administrative change. For several weeks, as the stock lost much of its value, workers stood by helplessly as their retirement savings evaporated. They were not allowed to switch investments at all — even though the plan had far less risky choices.

The unfortunate timing caps a year of pain for Enron’s workers. At the end of last year, the 401(k) plan had $2.1 billion in assets. More than half was invested in Enron, an energy conglomerate. Since then, the stock has lost 94 percent of its value.

At Portland General Electric, the Oregon utility acquired by Enron four years ago, some workers nearing retirement have lost hundreds of thousands of dollars. The utility has lined up grief counselors to help them work through their problems.

”We had some married couples who both worked who lost as much as $800,000 or $900,000,” said Steve Lacey, an emergency-repair dispatcher for Portland General. ”It pretty much wiped out every employee’s savings plan.”

The other dangerous issue that comes up when buying shares of the company you work for is insider trading. You can get in a lot of trouble if you trade stock in advance of public knowledge, where you would benefit from that knowledge to make huge gains or protect yourself from losses. As an insider and a full time employee at your company, you will have access to all kinds of information before the public, especially at executive levels. It can be very hard to keep track of what has been made public and what hasn’t. One wrong trade can get you in deep trouble with the SEC, a government agency that can impose large fines on you and even jail time.

The last problem with investing in your company’s stock is simple to understand: you have all of your eggs in one basket. If the company goes under, the value of your stock will plummet (possibly to 0) and your regular income is lost as your paychecks cease. This kind of financial hit can be devastating to recover from. With so many other investments to choose from, it’s just not worth the temptation to put all your investment dollars into a single company.

Most people, especially retirees who are accustomed to banking for many years, are well aware of what a certificate of deposit, or CD, is and how it works. While they don’t typically yield high returns, these investment vehicles are some of the safest investments an investor can make. The principal is guaranteed to be returned at the end of the term, and you get paid interest while you wait.

Since the financial crisis, however, CDs and savings accounts aren’t producing the returns that they used to, which has caused them to become less desirable savings vehicles. The current prolonged low interest environment is causing many savers to seek better returns elsewhere, which only compounds the problem because of the higher risk associated with higher returns. Unfortunately, Wall Street has picked up on this trend and has started marketing a new type of CD called a structured CD. This specialized CD provides better returns on the surface, but what is hidden in the fine print might shock you.

Wall Street has decided to take something that is already branded as being safe and sell it with extra bells and whistles that rack up big fees for them (sometimes as high as 3%) while increasing the risk for the investors. A recent Wall Street Journal article noted how one investor, a 79-year-old widow, was horrified to see her $100,000 investment immediately drop to $95,712 after incurring upfront fees. The fees had been disclosed in the 266-page agreement that she signed when investing in the product, but – as many investors would do — she didn’t read all 266 pages of the document. Unfortunately, she blindly trusted the bank that sold her this lump of coal.

The real travesty here is the fact that studies have shown that almost all of these products perform worse than standard CDs. In fact, a study of 118 structured CDs that were issued at least three years ago found that  only one-quarter posted returns better than those of an average five-year conventional CD.  To make matters worse, as of June 2016, roughly one-quarter of them produced no returns at all. At least your standard bank CD doesn’t charge you a fee to open it and most perform better than their fancy structured CD cousins.

So with new products like this popping up every day, how can you protect yourself? Well, here are just a few tips that will help you to not get yourself into an investment trap.

• Make sure you’re clear on the costs, fees and performance promises tied to any investment product.

• Always question products that promise high returns accompanied with low risks. These are classic indicators of Wall Street Scams or Ponzi Schemes.

• Focus on investing according to an investment plan that has been prepared alongside your trusted financial advisor. Having a plan and tracking progress makes you less apt to chase returns in riskier assets.

The world is saturated with these kinds of financial products. Using some standard common sense, sticking to a well-designed investment plan and working with a financial advisor on a regular basis can help you to avoid scams like the one mentioned here. Navigating the financial landscape can be difficult. As a rule of thumb, if something sounds too good to be true, it might just be.