Indexing

Indexing is an investment management strategy that attempts to replicate the investment performance of a market index. An index is a statistical measure of a market's value and performance and serves as a benchmark against which an investment manager's performance is judged. . Today,  a large number of index providers, including S&P, Dow Jones, MSCI, Russell, FTSE, and Morningstar, provide a wide range of indexes covering  US and  International stocks,  bonds, and commodities. A well managed, low cost index fund offers investors an excellent, if not optimal, investment vehicle for investing in the overall stock market, in discrete market segments, in the bond markets, and  in the commodity markets.

Structure
An index fund manager attempts to capture market returns by employing a number of management techniques. These include replicating or sampling the index universe of securities, equitizing cash balances to remain 100 percent invested, and by employing trading strategies that minimize transaction costs.

Replication
Indexes measuring large size and mid size companies usually buy and hold all of the stocks comprising a large cap or mid cap index. These stocks are held proportionally in the percentage weight a stock's market value stands in comparison to the market value of the index. Thus if Exxon Corp. has a value representing 3% of the index, an index fund replicating the index would hold a 3% weighting of Exxon in the fund. A replicated index fund should provide an expected return mirroring its index, reduced by the costs of managing the fund and the costs of transacting asset purchases and sales.

Sampling
Indexes which comprise a large number of small illiquid companies or illiquid bonds often make it very costly to fully replicate the index. Thus many small and micro cap index funds, as well as many bond index funds, sample their universe of securities. The sampling attempts to match the size and valuation metrics of the index. Because a sampled index fund does not hold all of the securities in the underlying index, its returns may vary somewhat from those of the index. Such performance variance is termed "sampling error."

Equitization
In order to reduce tracking error to its underlying index, index fund managers attempt to remain fully invested. Almost all mutual funds hold a cash balance, primarily to meet potential fund redemptions by fund investors.

This holding of cash will be a drag on fund returns during any period when stock returns outpace cash returns. Mutual funds hold cash as a result of shareholder cash flows into the fund (before the manager can purchase securities), as a holding from which to pay shareholder redemption of shares, and for active funds, a usual holding when the manager can not find securities of appealing valuation. Mutual funds tend to average 4 to 6 percent cash in their fund portfolios.

The index manager reduces the tracking error of holding cash balances by buying a futures contract (or sometimes an ETF) with the cash holdings. Since a futures contract is leveraged, an index manager can get an index return on a cash balance while waiting to efficiently invest a cash inflow directly into stocks, or to remain liquid in order to meet redemption of fund shares. Here is a simplified example.
 * 1) The index manager has a $500,000 cash balance.
 * 2) The index manager buys an index futures contract placing a $25,000 cash deposit for holding a $500,000 index futures position.
 * 3) The index manager now receives the index return on the futures ($500,000 worth assuming the futures track the index) while maintaining $475,000 cash liquidity from which to meet shareholder redemption requests.

This procedure is known as equitizing cash.

In another example, a manager might place a $10,000 margin deposit on a futures contract valued at $450,000. The manager can then place the remaining $440,000 into a short term interest paying account and still retain full market exposure from the $450,000 futures position.

Low Costs


According to the Investment Company Institute, the average expense ratio for US stock mutual funds in 2008 was 1.46% (weighted average 0.84%}, while the average expense ratio for US bond mutual funds was 1.07% (weighted average 0.63%).  Index funds are available to investors for expense ratios of 0.20% and lower from firms such as Vanguard, Fidelity, Schwab, and many Exchange Traded Funds . These low expenses mean that a greater portion of market returns accrue to the mutual fund shareholder where they can continue to compound, as opposed to being siphoned off through intermediaries.  As figure 1. demonstrates, indexing's cost advantage builds steadily over long holding periods.

In addition, indexing's consistent low costs result in greater than average relative performance over long holding periods.

In addition to low expense ratios, index funds can provide low transaction costs, which include brokerage commission costs, bid/ask spreads, and market impact costs (institutional purchases and sales can drive the price of a security up or down before the order is filled.)

Index funds reduce transaction costs through:


 * Low fund turnover. The longer the holding period for fund securities, the less trading is required.
 * Cross trading with other index funds. Whenever a stock migrates from one index to another (such as a small cap stock growing into a mid cap stock) an index manager will often trade the stock directly to another index fund, virtually eliminating transaction costs.
 * Patient (Block) trading. Index managers occasionally have the opportunity to offer to buy or sell a large block of thinly traded small company stocks. They can occasionally place an offer at low, or even negative spread costs and have it filled.

Tax Efficiency
 More On Tax Efficiency  Vanguard employs two additional mechanisms which improve index fund tax efficiency:
 * 1) For sales of mutual fund securities, Vanguard has selected a HIFO -highest in, first out-  accounting method. This means that the fund securities with the highest tax basis are sold first. This accounting method usually results in the fund realizing a loss or, at worst, a small gain when it sells securities.
 * 2) Most Vanguard index funds have an  exchange traded fund share class. When institutional creation and redemption of ETF shares occurs, Vanguard will select the lowest basis stock for the ETF creation basket and make an in-kind transfer of the securities out of the portfolio. This process gradually increases the tax basis of the remaining fund securities.


 * The tax distribution history of Vanguard Index funds can be found at Vanguard Funds: Distributions.

Due to lower fund turnover and longer holding periods, index funds tend to exhibit greater tax efficiency than actively managed funds. This is especially true for total market index funds, large cap index funds, and large growth index funds. These funds rarely realize and distribute a capital gain (and any small capital gains distributions are usually long term gains taxed at reduced tax rates.) The deferral of capital gains tax liabilities results in a tax-efficient index fund providing higher after tax returns to investors. In addition, since the advent of the tax regime for qualified dividends in 2004, well-managed total market and large cap indexes have been successful in providing investors with 100% qualified dividends, which are taxed at lower tax rates.

While total market, large cap, and large cap growth funds are very tax efficient, it is important to keep in mind that other size (small cap and mid cap) and style (value) indexes are much more likely to distribute taxable gains. When a small cap company grows into a mid cap or large cap company, or a value company becomes a growth company, an index manager will need to sell the stock once the stock migrates out of its current index. Usually this sale will result in the realization of a capital gain. For this reason (and for Value indexes higher dividend payouts) it is often recommended that these funds be placed in tax deferred or tax free retirement accounts.

The 2000-2002 and 2008 bear markets have improved the fundamental tax efficiency of all index funds, by providing substantial realized losses which can be used to offset future realized gains.

Asset Class Style Consistency
Once an investor has crafted an Investment Policy Statement and decided upon an asset allocation, the investor must then implement the plan by selecting appropriate mutual funds for the planned allocation. In addition to being low cost and tax efficient, index funds make suitable building blocks for asset allocation purposes because they can be trusted to remain reliably close to their declared style parameters. Thus, a US Total Stock Market Index fund will not hold international stocks; and an International Index fund will not hold US stocks. The tendency for funds to shift their center of style gravity is termed "style drift." Often, for example, an active Large Cap fund manager may invest in mid cap and small cap stocks, or add international stocks to the portfolio, or have the valuation style of the portfolio drift from value to growth. Such style drift takes the asset allocation control of the portfolio away from the investor and places it into the unpredictable hands of the fund manager. Another common example of style drift occurs when an active small cap fund grows exceptionally large. The fund usually must buy larger stocks, and will commonly see its center of style gravitate towards a mid cap style.

Many index providers have established trading bands about their size (large, mid, and small) and style (value and growth) indexes. These bands are designed to help index funds reduce turnover and transaction costs. The bands, however, introduce a modest degree of style drift in size and style index funds. The center of style gravity, however does not change. Thus, index funds allow the investor to control the asset allocation decision.

Reduced Manager Risk
Actively managed funds expose investors to two manager risks.
 * The risk that the manager will under perform the benchmark return,
 * The risk that the manager will leave the fund. For taxable investors, selling a fund after a manager change could result in a large capital gains tax.

Index funds greatly reduce these risks.
 * The risk of under performing a benchmark return is greatly reduced (although not eliminated, due to sampling and tracking errors.)
 * Index funds are managed by an investment team. The departure of a fund manager does not affect the management of the fund.

Simplicity
The low cost,  high tax efficiency, and long term consistency of performance advantages of indexing greatly simplify the task of fund selection and fund monitoring in an investment plan.

Expenses
A crucial advantage for index funds is low costs. Yet expense ratios on like index funds range from less than 0.20% to over 1.00%. It is therefore advisable for investors to select a low cost index fund over a like high cost index fund.

Front Running
The economy and the stock markets are dynamic. An index of the market is not static. As companies merge with and/or acquire other companies or fall into bankruptcy, some stocks must be deleted from indexes. As start up companies grow and mature they are added to indexes. For discrete size and style indexes stocks migrate between small cap, mid cap, and large cap indexes, as well as between value and growth indexes. To insure that indexes accurately reflect the market index providers periodically reconstitute the indexes (quarterly or annually.) For index fund managers tasked with mandates to track an index these reconstitution dates require the fund to either purchase or sell the stocks when they are added or deleted from the index. Since index provider's index changes are rules based and often pre-announced, active fund arbitraguers are able to purchase or short the stocks they believe are going to be added to or deleted from the indexes, knowing that the index fund managers are forced to buy or sell the stocks on the day of reconstitution. This strategy is known as index front running. In practice front running imposes market impact costs on index fund managers. Petajisto (2008) has studied this phenomenon from 1990-2005 and has found that the cost of front running increased from 1990-2000, peaking in 2000, and has declined since peaking. Petajisto (2008) conservatively estimates that over the full period the S&P 500 Index cost index funds an average 21-28 (additions/deletions) basis points per year in front running costs. The costs for the Russell 2000 index are estimated at 38-77 (additions/deletions) basis points.

Among the factors that can limit front running costs are the following:
 * 1) Index providers can add trading bands to their size and style indexes,thereby reducing the amount of turnover in the indexes.
 * 2) Index fund managers can use index benchmarks that do not have much indexed investment capital tied to the index.
 * 3) An index fund manager can be given trading freedom around the replication date so that sales and purchases can be executed both before and after the replication date. Such freedom comes at the expense of dutifully tracking the index.

Tracking Error
Tracking error is the ultimate measure of judging an index fund manager's performance. Since an index manager does not engage in security selection with an index fund, it is the manager's transactional skill which distinguishes performance. How well the manager uses index futures, cross trading, block trading, and manages trading around index reconstitution determines how close the manager can track the index benchmark.

The risk of large tracking error is greater for index funds which sample the index benchmark. This is especially true for index funds which track narrow market segments or single country international markets. Often such indexes contain a modest universe of securities and it is not uncommon for a single company to dominate the index. The 1940 Investment Company Act establishes diversification rules for mutual funds, and at times these dominate stocks in an index must be sold down to the regulatory holding limit (five-percent). This will obviously increase a fund's tracking error, not to mention increase the possibility for capital gains realization. Surprise events in the markets can also create tracking error for a sampled index, as was the case with the Vanguard Total Bond Index Fund in 2002. The sudden intensification of credit downgrades in mid 2002 resulted in the fund producing a -2.00% tracking error in 2002. The fund was the first retail bond index product offered. Its fortunes hit a snag in 2002, when it underperformed its benchmark by a full 2.00%. The Vanguard Bond Index Funds' Annual Report of 12/31/2002 discusses the situation. 
 * To understand what happened during 2002, one must focus on the remarkable turmoil that beset the bond market and the credit ratings of corporate bonds last summer. Here are a few points that illustrate the severity of the bond market's difficulties during mid-2002:


 * Lehman Brothers recently ranked the 50 worst credit blowups since 1989. (The list was made up of issues whose bonds had the worst one-month performances throughout the 14 years.) Of the 50 debacles, 32 occurred in 2002--and half of the total in July alone!


 * Many companies that suffered financial difficulties saw their bonds' credit ratings fall several notches from investment-grade status to the 'junk' level in a matter of days. Such rapid declines in credit quality struck even relatively healthy companies in troubled sectors.


 * By late summer, the returns of Baa-rated corporate bonds--the lowest level of investment-grade issues--were more than 8 percentage points below those of comparable Treasury securities, based on rolling two-month returns. This was by far the biggest gap since Lehman began tracking the returns in 1988. On two other occasions--during the deep recession of 1990 and the 1998 bond market turbulence that was precipitated by the collapse of hedge fund operator Long-Term Capital Management-- the underperformance of Baa rated bonds approached just 4 percentage points.


 * Although this extremely challenging market environment does not excuse our funds' shortfalls to their indexes, it does help to explain them. For our funds, the trouble began in June and intensified in July. As we explained in our report to you six months ago, our funds' returns will typically differ from those of the indexes for two primary reasons: The funds incur expenses that the indexes do not, and the funds' holdings do not exactly replicate those held by the indexes. The expense difference will always work against us in our goal of providing close tracking. The difference in holdings arises from our 'sampling' approach to indexing, which is necessary because it would be impractical and very costly to own all the bonds in the target indexes.


 * The sampling strategy--in which we buy some, but not all, of the securities in an index--is designed to provide our funds with characteristics that are similar to those of their targets. Our portfolio managers and analysts carefully select bonds so that the funds' weightings among sectors closely match those of the indexes. However, during June and July, the relative performance of some 'subsectors'--in contrast to historical experience--diverged widely. At that time, our funds had larger stakes than their indexes in several subsectors. In particular, at a subsector level we had heavier weightings in bonds issued by telecommunications and energy-trading companies. These groups were hit extremely hard by the WorldCom bankruptcy, the Enron scandal, and accounting irregularities at a number of other companies.


 * In recognition of the radical change in the market's reaction to credit risk, we have made some adjustments to ensure greater diversification and less exposure to lower-quality bonds. For example, we have taken our tight controls on sectors to the subsector level. These changes have already supported closer tracking of our target indexes. 

Academic Papers

 * Cai, Jie and Houge, Todd, "Index Rebalancing and Long-Term Portfolio Performance" (March 2007). Available at SSRN: http://ssrn.com/abstract=970839
 * Elton, Edwin J., Busse, Jeffrey A. and Gruber, Martin J., "Are Investors Rational? Choices Among Index Funds" (June 2002). NYU Working Paper Available at SSRN: http://ssrn.com/abstract=340482 or DOI: 10.2139/ssrn.10.2139/ssrn.340482
 * French, Kenneth R., "The Cost of Active Investing" (April 9, 2008). Available at SSRN: http://ssrn.com/abstract=1105775
 * Haslem, John A., Baker, H. Kent and Smith, David M., "Are Retail S&P 500 Index Funds a Financial Commodity? Insights for Investors." Financial Services Review, Vol. 15, No. 2, 2006. Available at SSRN: http://ssrn.com/abstract=1144763
 * Haslem, John A., Baker, H. Kent and Smith, David M.,"Performance and Characteristics of Retail S&P 500 Index Mutual Funds" (April 9, 2008). Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1144943
 * Petajisto, Antti, "The Index Premium and its Hidden Cost for Index Funds" (August 18, 2008). Available at SSRN: http://ssrn.com/abstract=1235604