At a Glance
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 criticisms of the EMH. 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 are purchased or sold and are thus subject to a form of passive management. The lack of active management generally gives the advantage of lower fees and, in taxable accounts, lower taxes.
The difference between the index performance and the fund performance is called the " tracking error ", or, colloquially, "jitter. Index funds are available from many investment managers. Less common indexes come from academics like Eugene Fama and Kenneth French , who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. Robert Arnott and Professor Jeremy Siegel have also created new competing fundamentally based indexes based on such criteria as dividends , earnings , book value , and sales.
Indexing is traditionally known as the practice of owning a representative collection of securities , in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index. 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. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing. Enhanced indexing is a catch-all term referring to improvements to index fund management that 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. The cost advantage of indexing could be reduced or eliminated by employing active management. Enhanced indexing strategies help in offsetting the proportion of tracking error that would come from expenses and transaction costs.
These enhancement strategies can be:. Because the composition of a target index is a known quantity, relative to actively managed funds, it costs less to run an index fund. Large Company Indexes to 0. The expense ratio of the average large cap actively managed mutual fund as of is 1.
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. Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-for-dollar basis.
Because index funds are passive investments, the turnovers are lower than actively managed funds. Style drift occurs when actively managed mutual funds go outside of their described style i. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk.
With an index fund, this drift is not possible and accurate diversification of a portfolio is increased. Index funds must periodically "rebalance" or adjust their portfolios to match the new prices and market capitalization of the underlying securities in the stock or other indexes that they track.
John Montgomery of Bridgeway Capital Management says that the resulting "poor investor returns" from trading ahead of mutual funds is "the elephant in the room" that "shockingly, people are not talking about. One problem occurs when a large amount of money tracks the same index. According to theory, a company should not be worth more when it is in an index. But due to supply and demand, a company being added can have a demand shock, and a company being deleted can have a supply shock, and this will change the price.
A fund may experience less impact by tracking a less popular index. Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error".
For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market. 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 volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire index would be considered diversified, but a bio-tech ETF would not.
This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.
Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization.
Asset allocation is the process of determining the mix of stocks , bonds and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon.
Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios. A combination of various index mutual funds or ETFs could be used to implement a full range of investment policies from low risk to high risk.
The relative appeal of index funds, ETFs and other index-replicating investment vehicles has grown rapidly  for various reasons ranging from disappointment with underperforming actively managed mandates  to the broader tendency towards cost reduction across public services and social benefits that followed the Great Recession.
In the United States, mutual funds price their assets by their current value every business day, usually at 4: Eastern time, when the New York Stock Exchange closes for the day.
Index ETFs are also sometimes weighted by revenue rather than market capitalization. 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.
An investor entered a mutual fund during the middle of the year and experienced an overall 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 overall 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. Typically mutual funds supply the correct tax reporting documents for only one country, which can cause tax problems for shareholders citizen to or resident of another country, either now or in the future. Note that if a PFIC annual information statement is provided, a careful filing of form is required to avoid punitive US taxation.
Technology Index Dow Jones U. Momentum Factor Index Fidelity U. Quality Factor Index Fidelity U. Treasury 20 Plus Year U. Healthcare Innovators Index Nasdaq U. Dollar price of Silver U. Dollar price of the Australian dollar U. Dollar price of the Brazilian Real U.