) is amutual fundorexchange-traded fund(ETF) designed to follow certain preset rules so that the fund cana specified basket of underlying investments.Those rules may include tracking prominentindexeslike the S&P 500 or theDow Jones Industrial Averageor implementation rules, such as tax-management, tracking error minimization, large block trading or patient/flexible trading strategies that allows for greater tracking error, but lower market impact costs. Index funds may also have rules that screen for social and sustainable criteria.

An index funds 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 byS&P Dow Jones Indicesfor theirS&P 500 Index. Equity index funds would include groups of stocks with similar characteristics such as the size, value, profitability and/or the geographic location of the companies. A group of stocks may include companies from the United States, Non-US Developed,emerging marketsorFrontier Marketcountries. 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. Think of an index fund as an investment utilizing rules-based investing. Some index providers announce changes of the companies in their index before the change date and other index providers do not make such announcements.2

The main advantage of index funds for investors is they dont require a lot of time to manage as the investors dont have to spend time analyzing various stocks or stock portfolios. Many investors also find it difficult to beat the performance of the S&P 500 Index due to their lack of experience/skill in investing.

One index provider, Dow Jones Indexes, has 130,000 indices. Dow Jones Indexes says that all its products are maintained according to clear, unbiased, and systematic methodologies that are fully integrated within index families.3

As of 2014, 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 (ETFs), have benefited from a trend toward more index-oriented investment products. From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in net new 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 2014.4

The first theoretical model for an index fund was suggested in 1960 byEdward RenshawandPaul Feldstein, both students at theUniversity of Chicago. While their idea for an Unmanaged Investment Company garnered little support, it did start off a sequence of events in the 1960s that led to the creation of the first index fund in the next decade.5

Qualidex Fund, Inc., a Florida Corporation, chartered on 05/23/1967 (317247) by Richard A. Beach (BSBA Banking and Finance, University of Florida, 1957) and joined by Walton D. Dutcher Jr., filed a registration statement (2-38624) with theSECon 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 MalkielwroteA 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:

What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out You cant buy the averages. Its time the public could.

…there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis…. Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.6

John Boglegraduated fromPrinceton Universityin 1951, where his senior thesis was titled: The Economic Role of the Investment Company.7Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research:Paul Samuelsons 1974 paper, Challenge to Judgment;Charles Ellis1975 study, The Losers Game; and Al Ehrbars 1975Fortunemagazinearticle on indexing. Bogle foundedThe Vanguard Groupin 1974; as of 2009, it was the largest mutual fund company in the United States.citation needed

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 Bogles folly.8In the first five year of Bogles company, it made 17 million dollars.9Fidelity InvestmentsChairmanEdward Johnsonwas quoted as saying that he [couldnt] believe that the great mass of investors are going to be satisfied with receiving just average returns.10Bogles fund was later renamed the Vanguard 500 Index Fund, which tracks theStandard and Poors 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 markets increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass theMagellan Fundbefore 2001, which it did in 2000.citation needed

John McQuown andDavid G. BoothofWells Fargo, andRex Sinquefieldof theAmerican National Bankin Chicago, established the first two Standard and Poors 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, whileIllinois Bellput in $5 million of their pension funds at American National Bank. In 1971,Jeremy Granthamand 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.11

In 1981, Booth and Sinquefield startedDimensional Fund Advisors(DFA), 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. Grauerat Wells Fargo harnessed McQuown and Booths indexing theories, which led to Wells Fargos pension funds managing over $69 billion in 198912and over $565 billion in 1998. In 1996, Wells Fargo sold its indexing operation toBarclays Bank of London, which it operated under the name Barclays Global Investors (BGI).Blackrock, Inc.acquired BGI in 2009; the acquisition included BGIs index fund management (both its institutional funds and its iShares ETF business) and its active management.

EconomistEugene Famasaid, 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 0.13A 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 (the profits to be made) do not exceed marginal costs.14Economists cite theefficient-market hypothesis(EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies thatfund managersand 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.15By 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 (including salaries, information costs, and trading costs). The conclusion is that most investors would be better off buying a cheap index fund. Note that return refers to theex-anteexpectation;ex-postrealisation of payoffs may make some stock-pickers appear successful. In addition, there have been manycriticismsof the EMH.

Tracking can be achieved by trying to hold all of thesecuritiesin 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 ofpassive management.

The lack ofactive managementgenerally gives the advantage of lower fees and, in taxable accounts, lower taxes. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is called thetracking error, or, colloquially, jitter.

Index funds are available from manyinvestment managers. Some common indices include theS&P 500, theNikkei 225, and theFTSE 100. Less common indexes come from academics likeEugene FamaandKenneth French, who created research indexes in order to develop asset pricing models, such as their Three Factor Model. TheFamaFrench three-factor modelis used byDimensional Fund Advisorsto design their index funds.Robert Arnottand ProfessorJeremy Siegelhave also created new competingfundamentally based indexesbased on such criteria asdividendsearningsbook value, andsales.

Indexing is traditionally known as the practice of owning a representative collection ofsecurities, in the same ratios as the target index. Modification of security holdings happens only periodically, when companies 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.S. dividend withholding taxes. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.

Enhanced indexingis a catch-all term referring to improvements to index fund management that emphasize performance, possibly usingactive 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 employingactive 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.1Typically expense ratios of an index fund range from 0.10% for U.S. Large Company Indexes to 0.70% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2015 is 1.15%.16If a mutual fund produces 10% return before expenses, taking account of the expense ratio difference would result in an after expense return of 9.9% for the large cap index fund versus 8.85% for the actively managed large cap fund.2

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.2Managing ones index fund holdings may be as easy as rebalancing every six months or every year.

Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result incapital gains taxcharges, 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. According to a study conducted byJohn Bogleover a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.2

Style drift occurs when actively managed mutual funds go outside of their described style (i.e., mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolios diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.2

Index funds must periodically rebalance or adjust their portfolios to match the new prices andmarket capitalizationof the underlying securities in thestock or other indexesthat they track.1718This allowsalgorithmic traders(80% of the trades of whom involve the top 20% most popular securities17) to performindex arbitrageby anticipating and trading ahead ofstock price movementscaused by mutual fund rebalancing, making a profit on foreknowledge of the large institutional block orders.1920This results in profits transferred from investors to algorithmic traders, estimated to be at least 21 to 28basis pointsannually forS&P 500index funds, and at least 38 to 77 basis points per year forRussell 2000funds.21In effect, an index, and consequently, all funds tracking an index are announcing ahead of time the trades that they are planning to make, allowing value to be siphoned byarbitrageurs, in a legal sic practice known as index front running.2223Algorithmichigh-frequency tradersall have advanced access to the index re-balancing information, and spend large sums on fast technology to compete against each other to be the firstoften by a few microsecondsto make these arbitrages.dubiousdiscuss

John Montgomery ofBridgeway Capital Managementsays 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.24Related time zone arbitrage against mutual funds and their underlying securities traded on overseas markets is likely damaging to financial integration between the United States, Asia and Europe.25

One problem occurs when a large amount of money tracks thesameindex. 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.2627This does not show up in tracking error since the index is also affected. A fund may experience less impact by tracking a less popular index.2829

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.

According toThe Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5basis pointsor less, but a Morningstar survey found an average of 38 basis points across all index funds.30

Diversificationrefers 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. AWilshire 5000index would be considered diversified, but a bio-techETFwould not.31

Since some indices, such as theS&P 500andFTSE 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 increasedvolatilityandinvestment riskfor an investor who seeks a diversified fund.32

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.33A global indexing strategy may have lower variance in returns than one based only on home market indexes, because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.

Asset allocationis the process of determining the mix ofstocksbondsand other classes of investable assets to match the investors 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 orETFscould be used to implement a full range of investment policies from low risk to high risk.

Research conducted by theWorld Pensions Council (WPC)suggests that up to 15% of overall assets held by largepension fundsand nationalsocial securityfunds are invested in various forms of passive strategies including index funds- as opposed to the more traditional actively managed mandates that still constitute the largest share of institutional investments34The proportion invested in passive funds varies widely across jurisdictions and fund type3435

The relative appeal of index funds, ETFs and other index-replicating investment vehicles has grown rapidly36for various reasons ranging from disappointment with underperforming actively managed mandates34to the broader tendency towardscost reductionacross public services and social benefits that followed the 2008-2012Great Recession.37Public-sector pensions and nationalreservefunds have been among the early adopters of index funds and other passive management strategies.3537

In the United States, mutual funds price their assets by their current value every business day, usually at 4:00p.m. Eastern time, when the New York Stock Exchange closes for the day.38IndexETFs, in contrast, are priced during normal trading hours, usually 9:30a.m. to 4:00p.m. Eastern time. Index ETFs are also sometimes weighted by revenue rather than market capitalization.39

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 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. TheIRSwould require the investor to pay tax on the capital gains distribution, regardless of the overall loss.

A small investor selling anETFto 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. US citizens/taxpayers living at home or abroad should particularly consider whether their investment in an ex-US fund (meaning the fund is administered by a foreign investment company) not providing annual 1099 forms (which report distributed income and capital gains/losses) or annual PFIC annual information statements will be subject to punitive US taxation under section 1291 of the US tax code. Note that if a PFIC annual information statement is provided, a careful filing of form 8621 is required to avoid punitive US taxation.4041

Reasonable Investor(s), Boston University Law Review, available at:

Fox, Justin (2011). Chapter 7: Jack Bogle takes on the performance cult (and wins).

. USA: HarperCollins. pp.111112.ISBN

Bogle, John (19501951).Senior Thesis,The Economic Role of the Investment Company

Bogle, John (2006).The First Index Mutual Fund: A History of Vanguard Index Trust and the Vanguard Index Strategy. Bogle Financial Center.

The Economist – World News, Politics, Economics, Business & Finance.

Ferri, Richard (2006-12-22).All About Index FundsMcGraw-Hill.

High-Frequency Firms Tripled Trades in Stock Rout, Wedbush Says.

Siedle, Ted (March 25, 2013).Americans Want More Social Security, Not Less.

Amery, Paul (November 11, 2010).Know Your Enemy.

Salmon, Felix (July 18, 2012).Whats driving the Total Return ETF?.

Petajisto, Antti (2011).The index premium and its hidden cost for index funds

Rekenthaler, John (FebruaryMarch 2011).The Weighting Game, and Other Puzzles of Indexing

Donnelly, Katelyn Rae; Edward Tower (2009). Chapter VIII. Time-zone arbitrage in United States mutual funds: Damaging to financial integration between the United States, Asia and Europe?.

Challenges and Opportunities for Trade and Financial Integration in Asia and the Pacific

. Studies in Trade and Investment 67. New York: United Nations Economic and Social Commission for Asia and the Pacific. pp.134165.ISSN1020-3516.

Market Reactions to Changes in the S&P 500 Index: An Industry Analysis

The Price Response to S&P 500 Index Additions and Deletions: Evidence of Asymmetry and a New Explanation

Arvedlund, Erin E. (2006-04-03).Keeping Costs Down – Barrons. Online.barrons.com

Tergesen, Anne; Young, Lauren dex Funds Arent All Equal.

Bogle, John C.(2004-04-13).As The Index Fund Moves from Heresy to Dogma . . . What More Do We Need To Know?.

Gale, MartinBuilding a Globally Efficient Equity Portfolio with Exchange Traded Funds

Rachael Revesz (27 Nov 2013).Why Pension Funds Wont Allocate 90 Percent To Passives.

Chris Flood (11 May 2014).Alarm Bells Ring for Active Fund Managers.

Mike Foster (6 June 2014).Institutional Investors Look to ETFs.

Rachael Revesz (7 May 2014).UK Govt. Leading Way For Pensions Using Passives.

Frequently Asked Questions About Mutual Fund Share Pricing.

. Archived fromthe originalon October 26, 2008

Bogle on Mutual Funds: New Perspectives for the Intelligent Investor

Mark T. Hebner, Foreword byHarry MarkowitzIndex Funds: The 12-Step Recovery Program for Active Investors, IFA Publishing; Updated and Revised, 2015,

Taylor Larimore, Mel Lindauer, Michael LeBoeuf,

FromBerkshire Hathaway2004 Annual Report; seeWikiquotesfor text.

Is Stock Picking Declining Around the World?The article argues that there is a move towards indexing.

The Lowdown on Index FundsInvestopedias introduction to Index Funds

False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated AlphasEvidence that stock selection is not a viable investing strategy.

The Prescient Are Few- …the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test cant eliminate the possibility that the few that did were merely false positives just lucky, in other words.

Largest index funds in terms of assets under management

(Venture capital fundMezzanine investment fundsVulture fund)

Loan qualifying investor alternative investment fund(LQIAIF)

Qualifying investor alternative investment fund(QIAIF)

Articles with unsourced statements from April 2018

Articles with disputed statements from October 2016

This page was last edited on 12 February 2019, at 02:40

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