An index fund (also known as index tracker) is a mutual fund or exchange-traded fund (ETF)
designed to follow certain preset rules so that the fund can track a specified basket
of underlying investments. Those rules may include tracking prominent indexes like the
S&P 500 or the Dow Jones Industrial Average or implementation rules, such as tax-management,
tracking error minimization, large block trading or patient/flexible trading strategies that
allows for greater tracking error, but lower market impact costs. Index funds may also
have rules that screen for social and sustainable criteria.
An index fund's rules of construction clearly identify the type of companies suitable for
the fund. The most commonly known index fund, the S&P 500 Index Fund, is based on the rules
established by S&P Dow Jones Indices for their S&P 500 Index. Equity index funds would include
groups of stocks with similar characteristics such as the size, value, profitability and/or
the geographic location of the companies. A group of stocks may include companies from
the United States, Non-US Developed, emerging markets or Frontier Market countries. Additional
index funds within these geographic markets may include indexes of companies that include
rules based on company characteristics or factors, such as companies that are small,
mid-sized, large, small value, large value, small growth, large growth, the level of gross
profitability or investment capital, real estate, or indexes based on commodities and
fixed-income. Companies are purchased and held within the index fund when they meet
the specific index rules or parameters and are sold when they move outside of those rules
or parameters. Think of an index fund as an investment utilizing rules-based investing.
Some index providers announce changes of the companies in their index before the change
date and other index providers do not make such announcements.
The main advantage of index funds for investors is they don't require a lot of time to manage
as the investors don't have to spend time analyzing various stocks or stock portfolios.
Many investors also find it difficult to beat the performance of the S&P 500 Index due to
their lack of experience/skill in investing. One index provider, Dow Jones Indexes, has
130,000 indices. Dow Jones Indexes says that all its products are maintained according
to clear, unbiased, and systematic methodologies that are fully integrated within index families.
As of 2014, index funds made up 20.2% of equity mutual fund assets in the US. Index domestic
equity mutual funds and index-based exchange-traded funds (ETFs), have benefited from a trend
toward more index-oriented investment products. From 2007 through 2014, index domestic equity
mutual funds and ETFs received $1 trillion in net new cash, including reinvested dividends.
Index-based domestic equity ETFs have grown particularly quickly, attracting almost twice
the flows of index domestic equity mutual funds since 2007. In contrast, actively managed
domestic equity mutual funds experienced a net outflow of $659 billion, including reinvested
dividends, from 2007 to 2014. Origins:
The first theoretical model for an index fund was suggested in 1960 by Edward Renshaw and
Paul Feldstein, both students at University of Chicago. While their idea for an "Unmanaged
Investment Company" did not garner too much support, it did set the ball rolling for a
sequence of events in 1960s that led to the creation of the first index fund in the next
decade. Qualidex Fund, Inc, a Florida Corporation,
Chartered 05/23/1967 (317247) by Richard A. Beach (BSBA Banking and Finance University
of Florida 1957) filed a registration statement (2-38624) with the SEC on October 20, 1970
which became effective July 31, 1972 "The fund organized as an open-end, diversified
investment company whose investment objective is to approximate the performance of the Dow
Jones Industrial Stock Average" In 1973, Burton Malkiel 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, What we need is a no-load, minimum management-fee
mutual fund that simply buys the hundreds of stocks making up the broad stock-market
averages and does no trading from security to security in an attempt to catch the winners.
Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen
are quick to point out "You can't buy the averages." It's time the public could.
...there is no greater service [the New York Stock Exchange] could provide than to sponsor
such a fund and run it on a nonprofit basis.... Such a fund is much needed, and if the New
York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do
it, I hope some other institution will. John Bogle graduated from Princeton University
in 1951, where his senior thesis was titled: "The Economic Role of the Investment Company".
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. 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. Vanguard started its first bond
index fund in 1986. Frederick L. A. Grauer at Wells Fargo harnessed
McQuown and Booth's indexing theories such that Wells Fargo's pension funds managed over
$69 billion in 1989 and over $565 billion in 1998. Wells Fargo sold its indexing operation
to Barclay's Bank of London, which it operated as Barclays Global Investors (BGI). In 2009,
Blackrock Inc acquired BGI; the acquisition included BGI's index fund management (both
institutional funds and its iShares ETF business) and its active management.
Economic theory: Economist Eugene Fama 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. 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. 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. Tracking:
Tracking can be achieved by trying to hold all of the securities 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 are thus subject to a form of passive management.
Fees: The lack of active management generally gives
the advantage of lower fees and, in taxable accounts, lower taxes. 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 called the "tracking error", or, colloquially, "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.
Indexing methods: Traditional indexing:
Indexing is traditionally known as the practice of owning a representative collection of securities,
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 indexing 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:
lower cost, issue selection, yield curve positioning,
sector and quality positioning and call exposure positioning.
Advantages: Low costs:
Because the composition of a target index is a known quantity, relative to actively
managed funds, it costs less to run an index fund. Typically expense ratios of an index
fund range from 0.10% for U.S. Large Company Indexes to 0.70% for Emerging Market Indexes.
The expense ratio of the average large cap actively managed mutual fund as of 2015 is
1.15%. If a mutual fund produces 10% return before expenses, taking account of the expense
ratio difference would result in an after expense return of 9.9% for the large cap index
fund versus 8.85% 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 tax 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.
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. Disadvantages:
Losses to arbitrageurs: Index funds must periodically "rebalance"
or adjust their portfolios to match the new prices and market capitalization of the underlying
securities in the stock or other indexes that they track.This allows algorithmic traders
(80% of the trades of whom involve the top 20% most popular securities) to perform index
arbitrage by anticipating and trading ahead of stock price movementscaused by mutual fund
rebalancing, making a profit on foreknowledge of the large institutional block orders. This
results in profits transferred from investors to algorithmic traders, estimated to be at
least 21 to 28 basis points annually for S&P 500 index funds, and at least 38 to 77 basis
points per year for Russell 2000 funds. In effect, an index, and consequently, all funds
tracking an index are announcing ahead of time the trades that they are planning to
make, allowing value to be siphoned by arbitrageurs, in a legal <sic> practice known as "index
front running".Algorithmic high-frequency traders all have advance access to the index
re-balancing information, and spend large sums on fast technology to compete against
each other to be the first—often by a few microseconds—to make these arbitrages.
John Montgomery of Bridgeway Capital Management says that the resulting "poor investor returns"
from trading ahead of mutual funds is "the elephant in the room" that "shockingly, people
are not talking about." Related "time zone arbitrage" against mutual funds and their
underlying securities traded on overseas markets is likely "damaging to financial integration
between the United States, Asia and Europe." Common market impact:
One problem occurs when a large amount of money tracks the same index. According to
theory, a company should not be worth more when it is in an index. But due to supply
and demand, a company being added can have a demand shock, and a company being deleted
can have a supply shock, and this will change the price. This does not show up in tracking
error since the index is also affected. A fund may experience less impact by tracking
a less popular index. 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, a well run
S&P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar
survey found an average of 38 basis points across all index funds.
Diversification: Diversification 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 have lower
variance in returns than 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 allocation is the process of determining the mix of stocks, 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. Pension investment in index funds:
Research conducted by the World Pensions Council (WPC) suggests that up to 15% of overall assets
held by large pension funds and national social security funds are invested in various forms
of passive strategies including index funds- as opposed to the more traditional actively
managed mandates that still constitute the largest share of institutional investments
The proportion invested in passive funds varies widely across jurisdictions and fund type
The relative appeal of index funds, ETFs and other index-replicating investment vehicles
has grown rapidly for various reasons ranging from disappointment with underperforming actively
managed mandates to the broader tendency towards cost reduction across public services and
social benefits that followed the 2008-2012 Great Recession. Public-sector pensions and
national reserve funds have been among the early adopters of index funds and other passive
management strategies. 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 ETFs, in contrast, are priced during normal trading hours, usually 9:30 a.m. to
4:00 p.m. Eastern time. Index ETFs are also sometimes weighted by revenue rather than
market capitalization. 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 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
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