We all bandy the word “index” about, but do we really consider what it means? An index is a market basket portfolio of investments to which we can compare the record of an actual mutual fund.
But if we say something is an index fund, the first question we should ask is, “Which index?” For example, we frequently compare a fund to “the market,” but that term usually refers to the S&P 500. Is it really valid to compare a small-cap emerging market fund to 500 of the largest U.S. companies? Yes and no: On one hand, we should compare like to like, so we look at a market basket index of the same focus. On the other hand, we may want to compare a specific fund to overall “market” indexes in deciding whether we should invest in the area at all.
Some questions to consider: Does an emerging market produce better long-term returns than, say, the S&P 500 or even an index of the broad international market? Is it more risky, and is there a good reason to take that risk? Are some market segments simply unattractive in general, or is a specific fund performing significantly worse than others of this kind?
In addition, indexes can be specifically chosen (by mutual fund companies or by services such as Morningstar) to produce certain results. For example, an international fund might be measured against the MSCI World Index includes large- and mid-cap securities from 23 developed countries (including the U.S.); the MSCI EAFE index uses 21 developed countries (excluding the U.S. and Canada). The FTSE Developed ex-U.S. includes Canada in its 24 countries.
In addition, an index can weight different countries and include or exclude some proportion of emerging markets. When you’re choosing an international fund for that segment of your portfolio, it’s important to be comparing funds based on similar or identical indexes, and that the index corresponds to what is actually in the portfolio.
In some cases you may be seeking a specific type of fund, but an actively managed fund might actually compare to a different index. In any case, Morningstar allows you to run comparisons not only of specific funds but also a variety of benchmarks. When trying to choose the best one for your needs, conduct these comparisons.