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An index fund or tracker can be defined as a mutual fund or exchange-traded fund (ETF) that tracks the result of a target market index. Good tracking can be achieved simply by holding all of the investments in the index, in the same proportions as the index; alternatively, statistical sampling may be used. This constant adherence to the securities held by the index is why these funds are referred to as passive investments.

Some common US market indexes include the S&P 500, the Wilshire 5000, the MSCI EAFE index, and the Lehman Aggregate Bond Index. Common UK indexes include the FTSE 100 and the FTSE All-Share Index.

Foundations of index funds

The Efficient Market Theory is fundamental to the creation of the index funds. The idea is that fund managers and stock analysts are constantly looking for securities that would out-perform the market. The competition is so effective that any new information about the fortune of a company will translate into movements of the stock price almost instantly. It is very difficult to tell ahead of time whether a certain stock will out-perform the market. Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2

If one cannot beat the market, then the next best thing is to cover all bases: owning all of the securities, or a representative sampling of the securities available on the market. Thus the index fund concept is born.

Low costs of index funds

Because the composition of a target index is a known quantity, it costs less to run an index fund. No stock analysts need to be hired. Typically the expense ratio of an index fund is below 0.2%. The expense ratio of the average mutual fund as of 2002 is 1.36% *. If a fund produces 7% return before expense, taking account of the expense ratio difference would result in after expense return of 6.8% versus 5.64%.

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. Richard A. Ferri, Protecting Your Wealth In Good Times and Bad, McGraw-Hill, 2002, table 12-2, page 190, ISBN 0-07-140817-7

Lower turnovers

Turnover refers to the selling and buying securities by the fund manager. Selling securities may result in capital gains tax, which would be passed on to fund investors. Because index funds are passive investments, the turnovers are lower than actively managed funds. The management consulting firm Plexus Group estimated in 1998 that for every 100% turnover rate, a fund would incur trading expense at 1.16% of total asset. *

Diversification

Diversification refers to the number of different securities in a fund. A fund with more numbers of securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces the impact of a single security performing very below average. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not. *

While an index like the Wilshire 5000 provides diversification within the category of U.S. companies, it does not diversify to international stocks. The Wilshire 5000 is dominated by large company stocks, and there is a question whether the large company dominance represents a reduction of diversity. Modern portfolio theory answers "no" *, but the picture could change if government's control on monopolies were allowed to weaken.

Asset allocation and achieving balance

The topic of asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets that would result in an optimal combination of expected risk and return matching the investor's appetite for and capacity to shoulder risk. A combination of various index mutual funds or ETF's may be used to implement such an investment policy whilst minimising administration costs. Jack Brennan, Straight Talk on Investing, Wiley, 2002, ISBN 0-471-26579-9

Comparison of index fund versus index ETF

Index funds are priced at end of day (4:00 pm), while index ETFs have intra-day pricing (9:30 am - 4:00 pm).

Some index ETFs have lower expense ratio as compared to regular index funds. However, brokerage expenses of index ETFs should not be over-looked.

Capital gains distribution

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 over-all 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 over-all 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.

Disadvantages of index funds

Since index funds achieve market returns, there is no chance of out-performing the market. On the other hand, it should not under-perform the market significantly. Investors should remember after all expenses and fees are subtracted their Rate of Return will not exactly be the market return of the index; however, it should be very close.

Owning a broad-based stock index fund does not make an investor immune to the effect of a stock market bubble. * When the US technology sector bubble burst in 2000, the general stock market dropped significantly, and did not recover until 2003.

Index fund vendors

Index funds are available from several firms including Vanguard, Fidelity, Barclays Global Investors and Dimensional Fund Advisors (DFA.). Vanguard is one of the early founders of index funds. Fidelity is a large mutual fund complex, and there are several index fund offerings from them. Barclays' index offerings are mostly Exchange Traded Funds. DFA funds are available from independent financial advisors. DFA's offerings have more "small value" style emphasis, due to Fama and French's study on stock returns.

Synthetic Indexing

Synthetic Indexing refers to 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 dividend withholding taxes. The bond portion can also hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing. *

Enhanced indexing

Enhanced Indexing refers to an approach to index fund management that uses a variety of techniques to create index funds that seek to emphasize performance, possibly using active managements. 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. Cost advantage of indexing could be reduced by employing active management.

Origins of the index fund

The history that lead to the creation of index funds can be traced back to 1654, see this extensive history of modern portfolio theory.

In 1973, Burton Malkiel published his book "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, to which the standard reply was made "of course, you can't buy an index." Malkiel said, "It's time the public can."

John C. Bogle graduated from Princeton in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote his inspiration 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 second largest Mutual Fund Company in the United States as of 2005.

When Bogle started the First Index Investment Trust on December 31, 1975, it was labeled Bogle's Follies and regarded as un-American, because it sought to achieve the averages rather than insisting that Americans had to play to win. This first Index Mutual Fund offered to individual investors 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, an astonishing growth rate of fifty percent per year. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000. "But in the financial markets it is always wise to expect the unexpected"

John McQuown 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 1981, Rex Sinquefield became chairman of Dimensional Fund Advisors (DFA), and McQuown joined its Board of Directors. DFA further developed indexed based investment strategies and currently has $86 billion under management (as of Dec. 2005). Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclay's Global Investors. It is one of the world's largest money managers with over $1.5 trillion under management as of 2005.

References

  • John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Dell, 1994, ISBN 0-440-50682-4
  • Taylor Larimore, Mel Lindauer, Michael LeBoeuf, The Bogleheads' Guide to Investing, Wiley, 2006, ISBN 0-471-73033-5
  • From Berkshire Hathaway 2004 Annual Report; see Wikiquotes for text.

See also

External links

Financial services | Investment | Funds

 

This article is licensed under the GNU Free Documentation License. It uses material from the "Index fund".

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