An index fund pools investors' money, and uses it to invest in securities, aiming to replicate an index of a particular financial market. It is typically a mutual fund or exchange-traded fund (ETF).[note 1]
A well-managed index fund gives investors a simple way to invest with low costs, better tax efficiency, style consistency, and lower manager risk. However, not every index fund is low cost, and active investors can exploit some indexes.
The key measure for assessing an index fund's efficiency is how well it tracks its benchmark index. This is called the tracking error of the fund. Replicating index funds will hold all the assets of the index in the correct proportion; other funds will approximate the index by sampling its holdings.
According to the Investment Company Institute the average expense ratio for US stock mutual funds in 2014 was 1.33% (weighted average 0.70%), while the average expense ratio for US bond mutual funds was 0.98% (weighted average 0.57%). You can find index funds with expense ratios of 0.20% and lower from firms such as Vanguard, Fidelity, Schwab. Also, many exchange-traded funds have similarly low costs. These low expenses mean that you receive more of the market returns than with higher costs, and your returns compound, rather than being paid to intermediaries. As Figure 1 shows, indexing's cost advantage builds steadily over long holding periods.[note 2]
Also, indexing's consistent low costs mean better than average relative performance over long holding periods.
As well as low expense ratios, stock market index funds have low transaction costs, including 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.)
Stock market index funds reduce transaction costs:
- Low fund turnover. There is less trading when a fund holds securities for longer periods.
- Cross trading with other index funds. When 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 sometimes place an offer at low, or even negative, spread costs and have it filled.
Because they trade less and have longer holding periods, stock market index funds tend to be more tax efficient 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). Deferring capital gains tax liabilities means higher after tax returns.
In addition, since the introduction of the tax regime for qualified dividends in 2004, well-managed total market and large cap index funds have been able to provide investors with 100% qualified dividends, taxed at lower rates.[note 3]
While total market, large cap, and large cap growth funds are very tax efficient, 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 realizes a capital gain. Because of this (and for value indexes higher dividend payouts) it is often recommended that you place these funds in tax deferred or tax free retirement accounts.
The 2000-2002 and 2008 bear markets improved the tax efficiency of all index funds, providing sizable realized losses which funds can use to offset future realized gains.[note 4]
Asset class style consistency
As well as being low cost and tax efficient, stock market index funds make suitable building blocks for asset allocations because you can trust them to remain reliably close to their stated style. That is, a US total stock market index fund will not hold international stocks; and an international index fund will not hold US stocks. Similarly, a US intermediate investment grade bond fund will not hold low-graded bonds or international currency bonds.
The tendency for funds to shift their center of style gravity is called "style drift". For example, an active large cap fund manager might invest in mid cap and small cap stocks, or add international stocks to the portfolio, or let the fund's valuation style drift from value to growth. Style drift takes your asset allocation control away from you, and into the unpredictable hands of the fund manager. Another common example of style drift is when an active small cap fund grows exceptionally large. The fund usually must buy larger stocks, so that its center of style gravitates 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 aim to help index funds reduce turnover and transaction costs, although they introduce a small amount of style drift in size and style index funds. The center of style gravity, however does not change. As a result, index funds allow you to remain in control of asset allocation.
Lower manager risk
Actively managed funds expose you 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 manager risks.
- The risk of under performing a benchmark return is lower (although not eliminated, due to sampling and tracking errors.)
- An investment team manages index funds. One fund manager leaving does not materially affect the management of the fund.
The low cost, high tax efficiency, and long term consistency of performance advantages of indexing all help to simplify how you select and monitor funds for your investment plan.
An index fund's crucial advantage is its low cost. However, expense ratios on similar index funds range from less than 0.20% to over 1.00%. It is therefore a good idea for you to select a low cost index fund over a similar high cost index fund.
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, indexes must delete some stocks. Similarly, as start up companies grow and mature, indexes must add them. 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 ensure that indexes accurately reflect the market, index providers periodically reconstitute the indexes (perhaps quarterly or annually). For index fund managers who must track an index, these events mean the fund must either purchase or sell the stocks, as they move into or out of an index.
Because the index provider's index changes are rules-based and often pre-announced, active fund arbitrageurs may be able to purchase or short the stocks they believe will 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 creates a market impact cost on index fund managers. Petajisto (2008) has studied this phenomenon from 1990-2005, and found that the cost of front running increased from 1990-2000, peaking in 2000, but has declined since. He 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 estimated costs for the Russell 2000 index are 38-77 (additions/deletions) basis points.
Among factors that can limit front running costs are:
- Index providers can add trading bands to their size and style indexes, which reduces the amount of turnover in the indexes.
- Index fund managers can use index benchmarks that do not have much indexed investment capital tied to the index.
- An index fund manager might be given trading freedom around the replication date, so that funds can sell and purchase both before and after the replication date. This freedom comes at the expense of precisely tracking the index.
Total market index funds should not have problems with front-running, because they own everything.
Tracking error is the ultimate measure of judging an index fund manager's performance. Because an index manager does not choose which securities an index fund holds, performance depends on the manager's transactional skill. How well the manager uses index futures, cross trading, block trading, and manages trading around index reconstitution determines how closely 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 stock index funds which track narrow market segments and single country international markets. These indexes contain a modest universe[note 5] of securities, and it is common for a single company to dominate the index. The 1940 Investment Company Act sets diversification rules for mutual funds, and at times funds must sell these dominant stocks in an index down to the regulatory holding limit (five-percent). This will obviously increase a fund's tracking error, and also increase the possibility of realizing capital gains.
Bond indexes tracking corporate bonds or municipal bonds also use sampling to mirror the market. Surprise events in the markets can also create tracking error for a sampled bond index. This happened with Vanguard'sTotal Bond Index Fund in 2002. The sudden intensification of credit downgrades in mid 2002 caused the fund to produce a -2.00% tracking error in 2002.[note 6]
Index fund structure
Broadly speaking, there are two main structures for ETFs. Physical ETFs are “plain-vanilla” products that replicate the index by simply reconstituting the basket of physical securities underlying the index. They are the dominant form of ETF, especially in the US. A Synthetic ETF is an investment that mimics the behavior of an exchange-traded fund (ETF) by using derivatives such as swaps, rather than owning the physical assets.
Physical ETFs are "plain-vanilla" products that replicate the index by simply reconstituting the basket of physical securities underlying the index. They are the dominant form of ETF, especially in the US.
An index fund manager attempts to capture market returns of the index using a number of management techniques. These include replicating or sampling the index universe[note 5] of securities, equitizing cash balances to remain 100 percent invested, and using trading strategies that minimize transaction costs.
Index funds tracking large size and mid size companies usually buy and hold all of the stocks comprising a large cap or mid cap index. Funds hold these stocks proportionally in the percentage weight a stock's market value has within the market value of the index.
For example, 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 give you a return that mirrors its index, reduced by the costs of managing the fund and the costs of asset purchases and sales.
Indexes which comprise a large number of small illiquid companies or illiquid bonds often make it very costly to fully replicate the index. Because of this, many small and micro cap index funds, as well as many bond index funds, sample their universe of securities.
Sampling tries 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. This performance variance is called "sampling error."
Sometimes sampling is called Physical replication with optimization. Optimization methods are model-driven, with a computer system making the buy and sell decisions. To reduce transaction costs, an ETF manager might use the physical replication with optimization if the index the fund is tracking contains too many securities.
Synthetic ETFs or swap-based replication
Instead of owning the physical assets, some funds replicate the index using derivatives (such as swaps). These are often called synthetic ETFs.
Synthetic ETFs are an advanced investing concept and not recommended for new investors. You need to understand these risks. Please read the main article and ask in the forum for guidance.
In order to reduce a funds tracking error relative to its underlying index, index fund managers try to remain fully invested. Almost all mutual funds hold a cash balance, primarily to meet potential fund redemptions by fund investors.
This cash holding creates a drag[note 7] on fund returns during any period when stock returns outpace cash returns.
Mutual funds hold cash because 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 cannot find securities that appeal. Mutual funds tend to average 4% to 6% cash in their fund portfolios.[note 8]
The index manager reduces the tracking error from holding a cash balance by buying a futures contract, or sometimes an exchange-traded fund (ETF), with the cash. Because 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.
- The index manager has a $500,000 cash balance.
- The index manager buys an index futures contract placing a $25,000 cash deposit for holding a $500,000 index futures position.
- 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 yet still have full market exposure from the $450,000 futures position.
- This article primarily talks about traditional market capitalization indexing. There are other indexes, based on alternate weighting methodologies. For more, see: Alternative indices.
- Both funds assume an initial $10,000 investment and an identical 8% annual growth. The time period is 30 years. The low-cost fund is no-load and has expenses of 0.2% per year. The high-cost fund has an initial 5.75% sales load, expenses of 2.0% per year, and a 0.25% 12b-1 fee.
- Mid cap and small cap index funds have not been as efficient in providing qualified dividends to investors. This may be because these indexes have a higher turnover than large cap indexes (qualified dividends have holding period requirements). Mid cap and small cap indexes also hold higher percentages of REITS, and their dividends are not qualified. See Percentages of REITs present in Vanguard index funds.
- See Vanguard accounting data spreadsheets for tax data on Vanguard index funds.
- A set of securities that shares a common feature such as the same market capitalization, industry or index. See: Universe Of Securities, from Investopedia.
- 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 December 31, 2002 discusses the situation.
- "Cash drag" is used to describe an additional "cost" hurdle that an active manager must exceed in order to beat a benchmark return. For an index manager, cash holdings will increase tracking error relative to the index.
- The latest number can be found at Monthly Trends in Mutual Fund Investing, from ICI.
- "ICI 2015 Investment Company Fact Book" (PDF). Retrieved June 3, 2023. Chapter Five.
- William Bernstein (1999). "The Magic of Percentile Compounding". Efficient Frontier. Retrieved June 3, 2023.
- See Vanguard Passive Fund Brokerage Commissions[dead link] for data
- W. Scott Simon. Index Mutual Funds. pp. 145–146. ISBN 0-9661172-7-1.
- William Bernstein (1998). "How to Beat the Benchmark". Efficient Frontier. Retrieved June 3, 2023.
- William Bernstein (2000). "Selection Skill, Transaction Skill". Efficient Frontier. Retrieved June 3, 2023.
- Robert H. Jeffrey; Robert D. Arnott (1993). "Is Your Alpha Big Enough To Cover Its Taxes?" (PDF). First Quadrant Corporation. Archived from the original (PDF) on November 2, 2022. Retrieved June 3, 2023.
- "ICI 2009 Investment Company Fact Book" (PDF). Retrieved June 3, 2023.
- Edwin J. Elton; Jeffrey A. Busse; Martin J. Gruber (2002). "Are Investors Rational? Choices Among Index Funds". NYU Working Paper. Retrieved June 3, 2023. Available from SSRN.
- Petajisto, Antti (August 18, 2008). "The Index Premium and its Hidden Cost for Index Funds". Retrieved June 3, 2023. Available from SSRN.
- "Understanding index front running". The Trade News. January 30, 2008. Archived from the original on October 23, 2008. Retrieved June 3, 2023.
- Bogleheads forum post:
- William Bernstein (2000). "Selection Skill, Transaction Skill". Efficient Frontier. Retrieved June 3, 2023.
- William Bernstein (2005). "Mea Culpa". Efficient Frontier. Retrieved June 3, 2023.
- W. Scott Simon. Index Mutual Funds. p. 139. ISBN 0-9661172-7-1.
- W. Scott Simon. Index Mutual Funds. pp. 139–140. ISBN 0-9661172-7-1.
- W. Scott Simon. Index Mutual Funds. pp. 144–145. ISBN 0-9661172-7-1.
- The Case For Indexing[dead link] Vanguard Investment Counseling & Research (October 2012).
- Myths and Misconceptions About Indexing[dead link] Vanguard Investment Counseling & Research (2003)
- Building a global core-satellite portfolio[dead link] Vanguard research (October, 2010)
- Three Challenges Of Investing: Active Management, Market Efficiency, and Selecting Managers. John Bogle. AXA Rosenberg Group Client Conference, Boston, Massachusetts. October 21, 2001
- The Arithmetic of Active Management. William F. Sharpe. Reprinted with permission from The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9. Copyright 1991
- Indexed Investing: A Prosaic Way to Beat the Average Investor. William F. Sharpe, Presented at the Spring President's Forum, Monterey Institute of International Studies. May 1, 2002