Index investing
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Index investing, also called indexing, is a method of passive investing whereby a fund (or individual) buys the same stocks in the same proportions as in a target index. The objective of this method is to buy and hold the index. Some advocates of index investing believe that technical analysis and fundamental analysis are flawed because they require the evaluation of the past performance of securities in order to predict future returns of the securities. The flaw of these investing methods is that past market returns are no indication of future returns.
Other advocates of index investing believe that even if technical analysis and fundamental analysis have no inherent flaws, the efficient markets hypothesis prevents any "skilled" manager from earning enough excess return (alpha (investment)) to justify his fees. This is due to the fact that there are millions of active economic agents in financial markets, so any clear opportunity for excess return is quickly priced away.
The return achieved by indexing is the return of the index. If the index tracks a market sector, then the return is that of the sector. If the index tracks the market as a whole, then the return is that of the market. Practitioners of indexing make a conscious decision not to try to outperform the market, rather they decide to obtain the market return.
Advantages of Index Investing
Lower Cost
Traditional mutual fund investments tend to be higher cost investments due to the turnover of equity components, which generate transaction fees with brokers. These fees reduce the overall return of the mutual fund portfolio.
Lower Risk
Smaller Cash Position
Lower Taxes
Due to much lower fund turnover, far lower capital gains taxes are realized for the investor.
Higher Traditional Returns
After accounting for management fees, index funds have traditionally earned superior returns to the average managed mutual fund.