Index fund
Encyclopedia
An index fund or index tracker is a collective investment scheme
(usually a mutual fund
or exchange-traded fund
) that aims to replicate the movements of an index
of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.
in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management
.
generally gives the advantage of lower fees and lower taxes in taxable accounts. Of course, the fees reduce the return to the investor relative to the index. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the "tracking error" or informally "jitter".
Index funds are available from many investment managers. Some common indices include the S&P 500
, the Nikkei 225
, and the FTSE 100. Less common indexes come from academics like Eugene Fama
and Kenneth French
, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama-French three-factor model
is used by Dimensional Fund Advisors
to design their index funds. Robert Arnott
and Professor Jeremy Siegel
have also created new competing fundamentally based indexes
based on such criteria as dividends, earnings
, book value
, and sales
.
wrote A Random Walk Down Wall Street
, which presented academic findings for the lay public. It was becoming well known in the lay financial press that most mutual funds were not beating the market indices. Malkiel wrote
John Bogle
graduated from Princeton University
in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson
's 1974 paper, "Challenge to Judgment", Charles Ellis
' 1975 study, "The Loser's Game", and Al Ehrbar's 1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group
in 1974; it is now the largest mutual fund company in the United States as of 2009.
Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly". Fidelity Investments
Chairman Edward Johnson was quoted as saying that he "[couldn't] believe that the great mass of investors are going to be satisfied with receiving just average returns". Bogle's fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index
. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market's increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund
before 2001, which it did in 2000.
John McQuown and David G. Booth
at Wells Fargo
and Rex Sinquefield
at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1971, Jeremy Grantham
and Dean LeBaron at Batterymarch Financial Management "described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the "Dubious Achievement Award" from Pensions & Investments magazine in 1972. Two years later, in December 1974, the firm finally attracted its first index client."
In 1981, David Booth and Rex Sinquefield started Dimensional Fund Advisors
(DFA), and McQuown joined its Board of Directors many years later. DFA further developed indexed based investment strategies.
Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclays Global Investors; it is one of the world's largest money managers.
said, "I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information." A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980))." A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)). Economists cite the efficient-market hypothesis (EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore that it is very difficult to tell ahead of time which stocks will out-perform the market. By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided.
In particular the EMH says that economic profits cannot be wrung from stock picking. This is not to say that a stock picker cannot achieve a superior return, just that the excess return will on average not exceed the costs of winning it (including salaries, information costs, and trading costs). The conclusion is that most investors would be better off buying a cheap index fund.
Note that return refers to the ex-ante
expectation; ex-post realisation of payoffs may make some stock-pickers appear successful. In addition there have been many criticisms of the EMH.
, in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index.
is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using active management
. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. The cost advantage of indexing could be reduced or eliminated by employing active management
. Enhanced indexing strategies help in offsetting the proportion of tracking error that would come from expenses and transaction costs. These enhancement strategies can be:
charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-for-dollar basis. Because index funds are passive investments, the turnovers are lower than actively managed funds. According to a study conducted by John Bogle
over a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.
According to The Vanguard Group
, a well run S&P 500 index fund should have a tracking error of 5 basis point
s or less, but a Morningstar survey found an average of 38 basis points across all index funds.
similar to the index minus fund costs.
In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due to arbitrage
urs, in a practice known as "index front running". The index fund, however, has suffered market impact
costs because they had to sell stock whose price was depressed, and buy stock whose price was inflated. These losses can be considered small, however, relative to an index fund's overall advantage gained by low costs.
refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire 5000
index would be considered diversified, but a bio-tech ETF
would not.
Since some indices, such as the S&P 500
and FTSE 100, are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility
and investment risk
for an investor who seeks a diversified fund.
Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization. A global indexing strategy may outperform one based only on home market indexes because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.
is the process of determining the mix of stock
s, bonds
and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios.
A combination of various index mutual funds or ETFs
could be used to implement a full range of investment policies from low risk to high risk.
s, on the other hand, are priced during normal trading hours, usually 9:30 a.m. to 4:00 p.m. Eastern time.
Scenario: An investor entered a mutual fund during the middle of the year and experienced an overall loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS
would require the investor to pay tax on the capital gains distribution, regardless of the overall loss.
A small investor selling an ETF
to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.
Collective investment scheme
A collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...
(usually a mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
or exchange-traded fund
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
) that aims to replicate the movements of an index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.
Tracking
Tracking can be achieved by trying to hold all of the securitiesSecurity (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management
Passive management
Passive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
.
Fees
The lack of active managementActive management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
generally gives the advantage of lower fees and lower taxes in taxable accounts. Of course, the fees reduce the return to the investor relative to the index. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the "tracking error" or informally "jitter".
Index funds are available from many investment managers. Some common indices include the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
, the Nikkei 225
Nikkei 225
The , more commonly called the Nikkei, the Nikkei index, or the Nikkei Stock Average , is a stock market index for the Tokyo Stock Exchange . It has been calculated daily by the Nihon Keizai Shimbun newspaper since 1950. It is a price-weighted average , and the components are reviewed once a year...
, and the FTSE 100. Less common indexes come from academics like Eugene Fama
Eugene Fama
Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...
and Kenneth French
Kenneth French
Kenneth Ronald "Ken" French is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business, Dartmouth College. He has previously been a faculty member at MIT, the Yale School of Management, and the University of Chicago Booth School of Business...
, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama-French three-factor model
Fama-French three-factor model
In asset pricing and portfolio management the Fama-French three factor model is a model designed by Eugene Fama and Kenneth French to describe stock returns....
is used by Dimensional Fund Advisors
Dimensional Fund Advisors
Dimensional Fund Advisors is an investment firm headquartered in Austin, Texas with regional offices in Amsterdam, Berlin, London, Santa Monica, Sydney, and Vancouver. The company was founded in 1981 by David G. Booth and Rex Sinquefield, both graduates of the University of Chicago Booth School of...
to design their index funds. Robert Arnott
Robert D. Arnott
Robert D. Arnott is an American entrepreneur, investor, editor and writer who focuses on articles about quantitative investing. He is the father of Richard Wiles-Arnott, Sydney Arnott, and Robin Arnott. He edited the CFA Institute's Financial Analysts Journal from 2002–2006, and has edited three...
and Professor Jeremy Siegel
Jeremy Siegel
Jeremy James Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania in Philadelphia, Pennsylvania...
have also created new competing fundamentally based indexes
Fundamentally based indexes
Fundamentally based indexes are indices in which stocks are weighted by one of many economic fundamental factors, especially accounting figures which are commonly used when performing corporate valuation, or by a composite of several fundamental factors...
based on such criteria as dividends, earnings
Earnings
Earnings are the net benefits of a Corporation's operation. Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT -- earnings before interest and taxes, EBITDA - earnings before...
, book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
, and sales
Sales
A sale is the act of selling a product or service in return for money or other compensation. It is an act of completion of a commercial activity....
.
Origins
In 1973, Burton MalkielBurton Malkiel
Burton Gordon Malkiel is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street...
wrote A Random Walk Down Wall Street
A Random Walk Down Wall Street
A Random Walk Down Wall Street, written by Burton Malkiel, a Princeton economist, is an influential book on the subject of stock markets which introduced the random walk hypothesis. Malkiel argues that asset prices typically exhibit signs of random walk and that one cannot consistently outperform...
, which presented academic findings for the lay public. It was becoming well known in the lay financial press that most mutual funds were not beating the market indices. Malkiel wrote
John Bogle
John Bogle
John Clifton "Jack" Bogle is the founder and retired CEO of The Vanguard Group. He is known for his 1999 book Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, which became a bestseller and is considered a classic.-Early life and education:Bogle was born in in Verona, New...
graduated from Princeton University
Princeton University
Princeton University is a private research university located in Princeton, New Jersey, United States. The school is one of the eight universities of the Ivy League, and is one of the nine Colonial Colleges founded before the American Revolution....
in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
's 1974 paper, "Challenge to Judgment", Charles Ellis
Charles Ellis
Charles Ellis is a deceased U.S. soccer midfielder who is best known for scoring a goal in each of the U.S. national team's first two games.-Professional:Ellis played several seasons for Brooklyn Celtic of the New York State Association Football League...
' 1975 study, "The Loser's Game", and Al Ehrbar's 1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group
The Vanguard Group
The Vanguard Group is an American investment management company based in Malvern, Pennsylvania, that manages approximately $1.6 trillion in assets. It offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. Founder...
in 1974; it is now the largest mutual fund company in the United States as of 2009.
Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly". Fidelity Investments
Fidelity Investments
FMR LLC or Fidelity Investments is an American multinational financial services corporation one of the largest mutual fund and financial services groups in the world. It was founded in 1946 and serves North American investors. Fidelity Ventures is its venture capital arm...
Chairman Edward Johnson was quoted as saying that he "[couldn't] believe that the great mass of investors are going to be satisfied with receiving just average returns". Bogle's fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market's increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund
Magellan Fund
The Fidelity Magellan Fund is a US-domiciled mutual fund from the Fidelity family of funds. It is perhaps the world’s best known actively managed mutual fund...
before 2001, which it did in 2000.
John McQuown and David G. Booth
David G. Booth
David G. Booth is co-founder and co-CEO of Dimensional Fund Advisors In 2008, he donated $300 million to the University of Chicago Graduate School of Business, which is the largest donation ever given to a business school....
at Wells Fargo
Wells Fargo
Wells Fargo & Company is an American multinational diversified financial services company with operations around the world. Wells Fargo is the fourth largest bank in the U.S. by assets and the largest bank by market capitalization. Wells Fargo is the second largest bank in deposits, home...
and Rex Sinquefield
Rex Sinquefield
Rex Sinquefield, 62, is a conservative businessman active in Missouri politics and philanthropic causes.-Background:Raised in in Saint Louis, Sinquefield received his MBA from the University of Chicago in 1972, his B.S. in 1967 from St. Louis University, where he is a member of the board of...
at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1971, Jeremy Grantham
Jeremy Grantham
Jeremy Grantham is a British investor and Co-founder and Chief Investment Strategist of Grantham Mayo Van Otterloo , a Boston-based asset management firm. GMO is one of the largest managers of such funds in the world, having more than US $107 billion in assets under management as of December 2010...
and Dean LeBaron at Batterymarch Financial Management "described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the "Dubious Achievement Award" from Pensions & Investments magazine in 1972. Two years later, in December 1974, the firm finally attracted its first index client."
In 1981, David Booth and Rex Sinquefield started Dimensional Fund Advisors
Dimensional Fund Advisors
Dimensional Fund Advisors is an investment firm headquartered in Austin, Texas with regional offices in Amsterdam, Berlin, London, Santa Monica, Sydney, and Vancouver. The company was founded in 1981 by David G. Booth and Rex Sinquefield, both graduates of the University of Chicago Booth School of...
(DFA), and McQuown joined its Board of Directors many years later. DFA further developed indexed based investment strategies.
Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclays Global Investors; it is one of the world's largest money managers.
Economic theory
Economist Eugene FamaEugene Fama
Eugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...
said, "I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information." A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980))." A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)). Economists cite the efficient-market hypothesis (EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore that it is very difficult to tell ahead of time which stocks will out-perform the market. By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided.
In particular the EMH says that economic profits cannot be wrung from stock picking. This is not to say that a stock picker cannot achieve a superior return, just that the excess return will on average not exceed the costs of winning it (including salaries, information costs, and trading costs). The conclusion is that most investors would be better off buying a cheap index fund.
Note that return refers to the ex-ante
Ex-ante
The term ex-ante is a neo-Latin word meaning "before the event". Ex-ante is used most commonly in the commercial world, where results of a particular action, or series of actions, are forecast in advance...
expectation; ex-post realisation of payoffs may make some stock-pickers appear successful. In addition there have been many criticisms of the EMH.
Traditional indexing
Indexing is traditionally known as the practice of owning a representative collection of securitiesSecurity (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
, in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index.
Synthetic indexing
Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favourable tax treatment, particularly for international investors who are subject to U.S. dividend withholding taxes. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.Enhanced indexing
Enhanced indexingEnhanced Indexing
In finance, enhanced indexing is a catch-all term that describes strategies employed to outperform traditional indexing. Enhanced indexing attempts to generate modest excess returns compared to index funds and other passive management techniques.-Features:...
is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using active management
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. The cost advantage of indexing could be reduced or eliminated by employing active management
Active management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
. Enhanced indexing strategies help in offsetting the proportion of tracking error that would come from expenses and transaction costs. These enhancement strategies can be:
- lower cost, issue selection, yield curve positioning,
- sector and quality positioning and call exposure positioning.
Low costs
Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. Typically expense ratios of an index fund ranges from 0.15% for U.S. Large Company Indexes to 0.97% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2005 is 1.36%. If a mutual fund produces 10% return before expenses, taking account of the expense ratio difference would result in an after expense return of 9.85% for the large cap index fund versus 8.64% for the actively managed large cap fund.Simplicity
The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as rebalancing every six months or every year.Lower turnovers
Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains taxCapital gains tax
A capital gains tax is a tax charged on capital gains, the profit realized on the sale of a non-inventory asset that was purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property...
charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-for-dollar basis. Because index funds are passive investments, the turnovers are lower than actively managed funds. According to a study conducted by John Bogle
John Bogle
John Clifton "Jack" Bogle is the founder and retired CEO of The Vanguard Group. He is known for his 1999 book Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor, which became a bestseller and is considered a classic.-Early life and education:Bogle was born in in Verona, New...
over a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.
No style drift
Style drift occurs when actively managed mutual funds go outside of their described style (i.e. mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.Possible tracking error from index
Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market.According to The Vanguard Group
The Vanguard Group
The Vanguard Group is an American investment management company based in Malvern, Pennsylvania, that manages approximately $1.6 trillion in assets. It offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. Founder...
, a well run S&P 500 index fund should have a tracking error of 5 basis point
Basis point
A basis point is a unit equal to 1/100 of a percentage point or one part per ten thousand...
s or less, but a Morningstar survey found an average of 38 basis points across all index funds.
Cannot outperform the target index
By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of returnRate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
similar to the index minus fund costs.
Index composition changes reduce return
Whenever an index changes, the fund is faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. The S&P 500 index has a typical turnover of between 1% and 9% per year.In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down, and the price of stock that has been added to the index tends to be driven up, in part due to arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
urs, in a practice known as "index front running". The index fund, however, has suffered market impact
Market impact
In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e. upward when buying and downward when selling...
costs because they had to sell stock whose price was depressed, and buy stock whose price was inflated. These losses can be considered small, however, relative to an index fund's overall advantage gained by low costs.
Diversification
DiversificationDiversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire 5000
Wilshire 5000
The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States. Currently, the index contains over 4,100 components...
index would be considered diversified, but a bio-tech ETF
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
would not.
Since some indices, such as the S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
and FTSE 100, are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
and investment risk
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
for an investor who seeks a diversified fund.
Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization. A global indexing strategy may outperform one based only on home market indexes because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.
Asset allocation and achieving balance
Asset allocationAsset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
is the process of determining the mix of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios.
A combination of various index mutual funds or ETFs
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
could be used to implement a full range of investment policies from low risk to high risk.
Comparison of index funds with index ETFs
In the United States, mutual funds price their assets by their current value every business day, usually at 4:00 p.m. Eastern time, when the New York Stock Exchange closes for the day. Index ETFExchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s, on the other hand, are priced during normal trading hours, usually 9:30 a.m. to 4:00 p.m. Eastern time.
U.S. capital gains tax considerations
U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains.Scenario: An investor entered a mutual fund during the middle of the year and experienced an overall loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
would require the investor to pay tax on the capital gains distribution, regardless of the overall loss.
A small investor selling an ETF
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains.
See also
- Exchange-traded fundExchange-traded fundAn exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
- Passive managementPassive managementPassive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
- Stock market indexStock market indexA stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
- Enhanced indexingEnhanced IndexingIn finance, enhanced indexing is a catch-all term that describes strategies employed to outperform traditional indexing. Enhanced indexing attempts to generate modest excess returns compared to index funds and other passive management techniques.-Features:...
External links
- Bogleheads.org - Investing advice inspired by the example of Jack Bogle
- The best investment advice you'll never get San Francisco Magazine article about the history and practice of Index funds, with commentary on mutual funds
- Is Stock Picking Declining Around the World? The article argues that there is a move towards indexing.
- The Lowdown on Index Funds Investopedia's introduction to Index Funds
- False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas Evidence that stock selection is not a viable investing strategy.
- The Prescient Are Few - ...“the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives” — just lucky, in other words.
- The Selection and Termination of Investment Management Firms by Plan Sponsors A study about the difficulty of hiring and firing investment managers. Summary: the fired managers beat the hired managers over the 3 years after the decision.