Friday, June 25, 2010

Equity Index Fund Basics

In this post I’ll cover a number of concepts related to mutual funds, using the Vanguard Total Stock Market Index fund to illustrate. I use this fund because it’s an excellent fund that everyone should consider including in their portfolio. You can learn a lot about this fund at the Vanguard web site. In the remainder of this post, I’ll refer to the Vanguard Total Stock Market Index fund by its ticker symbol, VTSMX.

Vanguard is a mutual fund company (a type of investment company), offering over 160 mutual funds. A mutual fund pools the money of many shareholders to buy securities such as stocks and bonds. Each share of the mutual fund represents ownership of a proportional share of the securities held by the fund; i.e., if you own one share of a mutual fund that holds 1000 stocks, you indirectly own a fraction of a share of each of the 1000 stocks. Thus, a key benefit of mutual funds is that they enable investors to easily and inexpensively diversify broadly among many stocks (or bonds).

VTSMX is an open-end, no-load, low-cost, equity, index mutual fund that seeks to track the performance of an index that measures the investment return of the broad US stock market. Yes, that was a mouthful, so let’s break it down.

Open-end: An open-end mutual fund has an unlimited number of shares available for purchase. The more mutual fund shares investors buy, the more securities (stocks or bonds) the mutual fund buys. By contrast, a closed-end fund sells a certain number of shares, is closed to new purchases, and then trades on an exchange like a stock. All Vanguard mutual funds are open-end.

No-Load: some mutual funds levy a sales charge (load), which may be as high as 5%. This extra fee may be paid to the mutual fund company, to a sales person (broker, insurance sales person, etc.), or both. All Vanguard funds, including VTSMX, are no-load; i.e., there is no sales charge. Your broker or insurance salesperson has no incentive to sell you a Vanguard fund, because they don’t make any money on it. There’s no evidence that load funds outperform no-load funds, so there’s no good reason to pay the extra fee to buy a load fund, but a broker will certainly try to convince you otherwise.

Low-cost: Mutual fund expenses are expressed as an expense ratio, which represents the fund’s annual operating expenses expressed as a percentage of average net assets. The expense ratio includes management fees, administrative fees, and any marketing and distribution fees. The expense ratio for VTSMX currently is 0.18%, which is 84% lower than the average expense ratio of funds with similar holdings.1 There are other costs that decrease investor returns, such as the costs related to the buying and selling of stocks (portfolio turnover); VTSMX portfolio turnover is very low.

Equity: Another word for stock. When you buy VTSMX you are investing in stocks (as opposed to bonds).

Index: An index fund doesn’t try to beat the market, but simply tries to track an index that represents a certain market or market segment. VTSMX seeks to track the MCSI US Broad Market Index, which represents the overall US stock market. As of May 31, 2010, VTSMX held 3,429 stocks. So, if you own a share of VTSMX, you own a fraction of a share of each of the 3,429 stocks that VTSMX holds; i.e., you own a little piece of most publicly traded companies in the US (excluding the smallest companies).

OK, so once again, VTSMX is a no-load, open-end, low-cost, equity, index mutual fund that seeks to track the performance of an index that measures the investment return of the broad US stock market

Shares of an open-end mutual fund, like VTSMX, trade (are bought and sold) only at the end of the day, after the market closes (in the case of VTSMX, the market is the NYSE). Open-end mutual fund shares don’t trade on an exchange like a stock, but are bought from or sold to the mutual fund company sponsoring the fund, which in the case of VTSMX is Vanguard. If you enter an order to buy or sell shares of VTSMX before 4pm Eastern Time (1pm Pacific) on a day the market is open (most business days), your order will be executed later that same day.2 If you enter the order later than 4pm Eastern, the order will be executed the next day the market is open. I always buy and sell shares using the Vanguard web site, but you also can do it by phone or mail.

Shares of an open-end mutual fund trade at Net Asset Value (NAV). This is the value of the fund’s assets, mostly made up of the securities it holds (US stocks in the case of VTSMX), minus liabilities, divided by the number of mutual fund shares. NAV is the price you pay or receive when you buy or sell a share of VTSMX, and the share price you see quoted on any financial web site such as Yahoo Finance or Google Finance (or Vanguard). NAV is determined at the end of each trading day by dividing the fund’s net assets by the total number of fund shares.3 As of 12/31/2009, total net assets of VTSMX were $58,004,042,000 (about $58B) and there were 2,113,205,103 (about 2.1B) shares; dividing the former by the latter yields a Net Asset Value per share of $27.45 (as of 12/31/2009).4

Vanguard also offers an Admiral Shares “share class” of the Total Stock Market Index fund (ticker symbol VTSAX), which has a lower expense ratio (0.07%), but the minimum investment is $100,000. The share class of the regular shares (VTSMX) is Investor Shares, with a minimum investment of $3,000.

Vanguard is unique in that it offers ETF (Exchange Traded Fund) shares as a share class of some of its mutual funds, including Total Stock Market Index; the ticker symbol for the ETF shares is VTI. ETFs offered by other companies are stand-alone funds, but Vanguard’s ETFs provide another way to purchase the same securities held by the corresponding mutual fund. The expense ratio is lower for the ETF shares (.07% for VTI). Another benefit of ETF shares is that the minimum purchase is the price of one share ($54.74 on 6/24/2010), instead of the $3,000 minimum for VTSMX.

Instead of buying or selling only at the end of the day, you buy or sell ETF shares any time the market is open (like a stock). The price you pay will be close to NAV, but since the exact price is determined by supply and demand at that moment, you probably will pay slightly more or less than NAV. Vanguard now offers commission-free trades for its ETFs, so there’s now one less expense to consider in using Vanguard ETFs (if you use a Vanguard brokerage account).


1. Vanguard is unique in that the company is owned by the mutual funds, which in turn are owned by the mutual fund shareholders (investors). Vanguard does not make a profit, but charges mutual fund shareholders only what it costs to run the funds. In doing business this way, Vanguard is able to offer investors mutual funds at much lower costs than the industry average.

2. To be more precise, the order will be executed the same day if you have money in another Vanguard fund (e.g., a money market fund) that you can exchange for shares of the fund you want to buy. If you are buying using an electronic transfer from a bank, your purchase will be executed on the following business day if the order is received before 10pm Eastern time, and the second business day if received later than that..

3. For Vanguard funds with multiple share classes, such as Total Stock Market Index, NAV actually is determined separately for each share class (Investor, Admiral, ETF); i.e., the proportion of the mutual fund net assets for each share class are divided by the number of shares for that share class. On 5/31/2010, the Total Stock Market Index fund had total assets of $126.5B, $61.3B of which consisted of Investor Shares (VTSMX).

4. I found the numbers for total assets and number of shares in Form N-CSR - Certified Shareholder Report on the SEC web site, and on page 115 of the annual report at

No comments:

Post a Comment