Index fund

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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. 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 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. In addition it is impossible to precisely mirror the index as 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'.

Index funds are available from many investment managers. Some common indices include the S&P 500, the Wilshire 5000, the FTSE 100 and the FTSE All-Share Index.

1 Origins of the index fund
2 Economic theory
3 Indexing methods
- 3.1 Synthetic indexing
- 3.2 Enhanced indexing
4 Advantages
5 Disadvantages of index funds
- 5.1 No Chance of Out-Performing
- 5.2 The Objective To Minimize Tracking Errors Causes Losses
6 Diversification
7 Asset allocation and achieving balance
8 Comparison of index fund versus index ETF
9 US Capital gains tax considerations
10 References
11 See also
12 External links

[edit] 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 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. 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; 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. "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 Barclays Global Investors; it is one of the world's largest money managers with over $1.5 trillion under management as of 2005.

[edit] Economic theory

Economists cite the efficient market theory as the fundamental premise that justifies the creation of the index funds. The theory states that fund managers and stock analysts are constantly looking for securities that may out-perform the market; and that 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 postulated therefore that it is very difficult to tell ahead of time whether a certain stock will out-perform the market. ^[1] By creating an index fund that mirrors the whole market it is believed the inefficiencies of stock selection are avoided.

It should be noted that significant portions of the worldwide investment management industry do not wholly subscribe to this premise. Actively managed funds are popular and some are consistently successful. This is a point of academic contention.

[edit] Indexing methods

[edit] 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 also hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing. [1]

[edit] Enhanced indexing

Enhanced indexing is an approach to index fund management that uses a variety of techniques to create index funds that seek to 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. Cost advantage of indexing could be reduced by employing active management.

[edit] Advantages

[edit] Low costs

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%^{[citation needed]}. The expense ratio of the average mutual fund as of 2002 is 1.36% [2]. If a fund produces 7% return before expenses, taking account of the expense ratio difference would result in an after expense return of 6.8% versus 5.64%.

[edit] 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. ^[2]

[edit] Lower turnovers

Turnover refers to the selling and buying securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometime passed on to fund investors. Because index funds are passive investments, the turnovers are lower than actively managed funds^{[citation needed]}. 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. [3]

[edit] Disadvantages of index funds

[edit] No Chance of Out-Performing

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 diversified stock index fund does not make an investor immune to systematic risk (e.g., a stock market bubble). [4] When the US technology sector bubble burst in 2000, the general stock market dropped significantly, and did not recover until 2003.

[edit] 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. As a result, the price of the stock that has been removed from the index tends to be driven down. The price of stock that has been added to the index tends to be driven up. These price changes tend to persist for 2-4 weeks. 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.

[edit] 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 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. [5]

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. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.

[edit] Asset allocation and achieving balance

Main article: Asset allocation

Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor's attitude towards investment risk and anticipated investment returns. 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. ^[3]

[edit] 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.

[edit] US 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 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.

[edit] References

^ Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton, 1996, ISBN 0-393-03888-2
^ Richard A. Ferri, Protecting Your Wealth In Good Times and Bad, McGraw-Hill, 2002, table 12-2, page 190, ISBN 0-07-140817-7
^ Jack Brennan, Straight Talk on Investing, Wiley, 2002, ISBN 0-471-26579-9

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.