Index fund
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An index fund is a type of passively managed mutual fund that seeks to track the performance of a benchmark market index such as the S&P 500.
In theory, this could be achieved simply by holding all of the investments represented by the index, in the same proportions as their representation in the index. In practice, however, actual index funds depart from exact indexation in several ways:
- keeping some assets in cash to cover redemptions;
- using a large representative sample of index components instead of all of them;
- actively managing a small portion of the portfolio in the hope of compensating for transaction costs, which would otherwise cause the fund's performance to fall slightly short of the index.
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Advantages
Over time, index funds have outperformed the average actively-managed fund in the equivalent asset class. That is, some actively-managed large-cap funds may beat the S&P 500 index, but the average large-cap fund does not. Another advantage is a lower expense ratio; by using a public index to determine the makeup of a fund, fund managers can forgo expensive research costs. (However, the trademark owners of the well-known indexes can and do charge index funds a stiff fee for their use of the trademarked name). Index funds also tend to incur lower capital gains taxes and fees, as they generally hold securities for longer terms than more aggressively managed funds.
Most importantly, because an index fund is more diversified than a typical portfolio or fund, the risk is lessened, thereby increasing overall performance in an upward market. Index Mutual Funds: Profiting from an Investment Revolution, by W. Scott Simon (1998), presents the best modern analysis of the advantages of index funds, including a discussion of how Modern Portfolio Theory, developed by Nodel Prize winner Harry Markowitz, suggests that the greater diversification of index funds make them presumptively superior to active forms of investment.
Indeed, no actively managed fund of any type (including corporations that function like closed end mutual funds like Berkshire Hathaway and Liberty Media) have outperformed the market for more than 40 years, and 99% of them (that do exist or have existed) have not outperformed the market for more than 10 years.
Disadvantages
One of the suggested disadvantages of index funds is the same as one of its suggested advantages, the fact that they have a low "turnover" (the components of an index change infrequently). This can potentially expose the fund to greater risk in a sudden downturn. Furthermore, since index funds are designed to track broad swings of the stock market rather than collecting individual stocks that "beat the market", they may not be ideal for short-term investors.
However, it should be noted that managed funds have traditionally not been very sucessful at predicting sudden downturns in the market and thus taking appropriate action.
Origins of the index fund
In 1951, John C. Bogle, then a student at Princeton University, wrote a senior thesis entitled: "Mutual Funds can make no claims to superiority over the Market Averages." 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." Partly in response to Malkiel, Bogle founded The Vanguard Group in 1974, and on December 31, 1975, the Vanguard Index Trust became the first index fund ever offered to the public. The fund exists today under the name "Vanguard 500 Index Fund" which is currently the largest Index Fund, and due to economies of scale, the fund with the lowest management fees.