Retirement Planning - F is for Free-Float

F is for Free-Float

One of the best reasons to use an index fund in your retirement plan that is modeled on the benchmark S&P 500, besides the low cost is the methodology employed by the index to get the best possible measure of how your investment is doing. While all of the stocks in the S&P 500 are considered large-caps, the way they are capitalized is not necessarily uniform.

The simplest way to determine market capitalization is to multiply the price of the shares times the number of shares. This unfortunately makes the mistake of including shares of stock that are held inside the company and are not available for trade part of the company’s total worth.

A company is only as good as the price of its shares. The more shares that are available to the marketplace, the better this yardstick becomes as a measure. Closely held shares that are literally “off-the-market” blur the overall picture.

By using a method called free-float, the indexes can accurately determine what the true market value of a company is. The S&P 500 uses this method in its index.

Free-float drops those restricted shares, ownership holdings and other blocks of stock not available for the public and considers only the shares that could be traded.

These broad indexes have had a reputation for long-term out-performance. Out-performance is a nice way of saying they did better than funds that are similar and for some very obvious reasons. The high cost of running an actively managed fund means that the actively managed fund must overcome those costs in performance percentages before they can begin to post competitive returns.



A is for Asset Allocation

B is for Balance

C is for Continuity

D is for Diversity

E is for (Tracking) Errors

Retirement Planning - E is for Errors - Tracking Errors

E is for (Tracking) Errors

Indexes play an important role in retirement planning. Numerous people use them for their ease of use and convenience (many are located in your company sponsored 401(k) plans) and most importantly, their low cost.

The index funds that do the best job do so because they excel at penny pinching. And that takes more than just a smattering of skill. They must maintain the underlying portfolio, making moves seemingly in an instant each time the index re-balances (doing so before the rest of the traders increase the price of the stock that was added and deflating the stock that is being sold out of the index).

Any difference between the index’s benchmark and the underlying portfolio is considered a tracking error. These tracking errors are particularly pronounced during an unsettled market. Index fund managers may have enormous amounts of cash sitting idly on the sidelines as the markets adjust to news.

They would like to invest it but they, much like the rest of us, are gripped in fear that where they put their money will be the wrong place. Unsure of beefing up one position in favor of another, the money languishes, largely un-invested, while the benchmark moves ahead in most instances, completely unfazed by these decisions.

Measuring These Errors

Just when you thought all you had to do was buy and index and forget about it, along comes this paradox. But how do determine how much of an error is acceptable? The simple answer is chose a fund that is closest to the benchmark. But in the real world, that fund may not be accessible to you (perhaps it is too costly to buy into to or your retirement plan at work doesn’t offer such a beast). In that case, use this measure.

If over the course of a year – not a quarter or a half a year – your index fund’s return is more that five basis points lower than the return posted by the benchmark, you should consider moving your money.

A is for Asset Allocation

B is for Balance

C is for Continuity

D is for Diversity