Index fund
An index fund is a mutual fund or exchange-traded fund designed to follow certain preset rules so that it can replicate the performance of a specified basket of underlying securities.
The main advantage of index funds for investors is that they are difficult to outperform consistently. Academic research has consistently found that most active investors within a given market segment underperform the relevant index after fees and taxes. Investors also do not need to spend time analyzing various stocks or stock portfolios. Thus investors, academicians, and authors such as Warren Buffett, John C. Bogle, Jack Brennan, Paul Samuelson, Burton Malkiel, David Swensen, Benjamin Graham, Gene Fama, William J. Bernstein, and Andrew Tobias have long been strong proponents of index funds.
Index funds tracking many different indexes are available. Global diversification can be achieved using funds that track the MSCI World or FTSE Global Equity Index Series. Index funds are widely available at low cost for retail investors worldwide, but especially so in the United States, Canada, and Europe.
Construction
Index funds generally aim to hold each security in an index in its respective weight. The most popular indexes are market capitalization weighted, and such index funds hold greater amounts of larger companies and lesser amounts of smaller companies. Other index construction methods include equal-weighting or price weighting, although these have declined in popularity. Index funds may have other implementation rules designed to minimize taxes, reduce tracking error, or reduce trading costs. Some index funds utilize large block trading or patient/flexible trading strategies that aim to minimize market impact and adverse selection costs. Index funds may also have rules that screen for social and sustainable criteria.The amount of tracking error depends on trading costs, which vary based on the liquidity in a market. Popular index funds in highly liquid markets can match index performance within 0.01%, while index funds in emerging markets can have substantial tracking error. While index funds are considered a form of passive management, the internal plumbing of index funds can be complex, with a team of managers executing trades on behalf of the fund.
An index fund's rules of construction clearly identify the type of companies suitable for the fund. The most commonly known index fund in the United States, 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 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.
While index providers often emphasize that they are for-profit organizations, index providers have the ability to act as "reluctant regulators" when determining which companies are suitable for an index.
Some index providers announce changes of the companies in their index before the change date whilst other index providers do not make such announcements.
Market size
, 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, have benefited from a trend towards more index-oriented investment products. From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in new net 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 the University of Chicago. While their idea for an "Unmanaged Investment Company" garnered little support, it did start off a sequence of events in the 1960s.Qualidex Fund, Inc., a Florida Corporation, chartered on May 23, 1967 by Richard A. Beach and joined by Walton D. Dutcher Jr., filed a registration statement with the SEC on October 20, 1970 which became effective on 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", thereby becoming the first index fund.
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 popular 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 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; as of 2009 it was the largest mutual fund company in the United States.
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". In the first five years of Bogle's company, it made 17 million dollars. Fidelity Investments Chairman Edward Johnson was quoted as saying that he " 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 of Wells Fargo, and Rex Sinquefield of the American National Bank in Chicago, established the first two 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, Booth and Sinquefield started Dimensional Fund Advisors, and McQuown joined its board of directors. 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, which led to Wells Fargo's pension funds managing over $69 billion in 1989 and over $565 billion in 1998. In 1996, Wells Fargo sold its indexing operation to Barclays Bank of London, which it operated under the name Barclays Global Investors. Blackrock, Inc. acquired BGI in 2009; the acquisition included BGI's index fund management 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 do not exceed marginal costs.
Economists cite the efficient-market hypothesis 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. 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 criticism of the EMH.
Some legal scholars have previously suggested a value maximization and agency-costs theory for understanding index funds stewardship.''''''