An investment fund where shares are bought in all the companies listed in the main stock exchange index, then held. In this way the portfolio of shares will always equal movements in the stock market. The strategy is attractive where there is a fear of underperforming the market. It is more popular in the USA than in the UK.
An index fund or index tracker is a collective investment scheme that aims to replicate the movements of an index of a specific financial market.
Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Many index funds rely on a computer model with little or no human input in the decision as to which securities to purchase and is therefore a form of passive management.
The lack of active management gives the advantage of lower fees than actively managed funds however the fees will always reduce the return to the investor relative to the index. The difference between the index performance and the fund performance is known as the tracking error.
Index funds are available from many investment managers.
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. 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."
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 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.
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. "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. 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.
Economic theory
Economists cite the efficient market theory as the fundamental premise that justifies the creation of the index funds. By creating an index fund that mirrors the whole market it is believed the inefficiencies of stock selection are avoided.
Indexing methods
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.
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.
Advantages
Low costs
Because the composition of a target index is a known quantity, it costs less to run an index fund. Typically the expense ratio of an index fund is below 0.2%.
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 securities by the fund manager. Because index funds are passive investments, the turnovers are lower than actively managed funds.
Disadvantages of index funds
No Chance of Out-Performing
Since index funds achieve market returns, there is no chance of out-performing the market. Investors should remember after all expenses and fees are subtracted their Rate of Return will not exactly be the market return of the index;
Owning a diversified stock index fund does not make an investor immune to systematic risk (e.g., a stock market bubble).
The Objective To Minimize Tracking Errors Causes Losses
The stated objective of index funds (in their prospectus) is to minimize the tracking error as they follow the designated index. Whenever an index changes, the fund then, is faced with the prospect of dumping all the stock that has been removed from the index, and purchasing the stock that was added to the index. The index fund, however, has suffered permanent losses because they had to sell stock whose price was depressed, and buy stock whose price was inflated. All in all, however, these loses are small relative to an index fund's over-all advantage gained by its overall total low costs.
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.
Since some indicies like 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. Index funds can play an important part in selecting asset classes that conveniently reflect whole markets and can make up an important part of a balanced portfolio.
A combination of various index mutual funds or ETF's could be used to implement such an investment policy.
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.
US Capital gains tax considerations
U.S. mutual funds are required by law to distribute realized capital gains to their shareholders.
Scenario: An investor entered a mutual fund during the middle of the year and experienced an over-all loss for the next 6 months.
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