Index fund

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An index fund is a fund that pools investors capital for the purpose of investing in securities, typically a mutual fund or exchange-traded fund (ETF), that aims to replicate the movements of an index of a specific financial market.[note 1]

A well-managed index fund provides investors with a simple way to access such advantages as low costs, improved tax efficiency, style consistency and reduced manager risk. Investors should be mindful that not all index funds are low cost and that some indexes can be exploited by active investors.

The key measure for accessing 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.

Advantages

Low costs

According to the Investment Company Institute[1], 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%).[2] 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.

Figure 1: Investment growth of both a low-cost and high-cost fund[note 2]

Highcost-lowcost.jpg

Furthermore, indexing's consistent low costs result in greater than average relative performance over long holding periods.[3]

In addition to low expense ratios, stock market index funds can provide low transaction costs, which include brokerage commission costs[4], 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 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.[5]
  • 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.[6] [7]

Tax efficiency

Due to lower fund turnover and longer holding periods, stock market 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.[8] In addition, since the advent of the tax regime for qualified dividends in 2004, well-managed total market and large cap index funds have been successful in providing investors with 100% qualified dividends, which are taxed at lower tax rates.[note 3]

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.[9]

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, stock market 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. A US intermediate investment grade bond fund will not be holding low-graded bonds or international currency bonds.

The tendency for funds to shift their center of style gravity is termed "style drift." 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 manager 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.

Caveats

Expenses

A crucial advantage for index funds is low costs. However, expense ratios on similar index funds range from less than 0.20% to over 1.00%.[10] It is therefore advisable for investors to select a low cost index fund over a similar high cost index fund.[11]

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 ensure 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 as they are added or deleted from the index. Since 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 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.[12]

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 precisely tracking the index.[13]

Total market index funds shouldn't have an issue with front-running because they own everything.[14]

Tracking error

Main articles: Indexing and 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.[15] 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 stock index funds which track narrow market segments and single country international markets. 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[16] establishes diversification rules for mutual funds, and at times these dominant stocks in an index must be sold down to the regulatory holding limit (five-percent).[17] This will obviously increase a fund's tracking error, not to mention increase the possibility of realizing capital gains.

Bond indexes tracking corporate bonds or municipal bonds also employ sampling to mirror the market. Surprise events in the markets can also create tracking error for a sampled bond 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.[note 4]

Index fund structure

An index fund manager attempts to capture market returns of the index by employing 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 by employing trading strategies that minimize transaction costs.

Replication

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. 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.[18]

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." [19]

Sometimes this is called Physical replication with optimization: Optimization methods are model-driven, with a computer system making the buy and sell decisions. The ETF manager may use the physical replication with optimization if the index being tracked contains too many securities, and the ETF manager would like to reduce transaction costs.

Swap-based replication

Certain funds perform replication of the index using derivatives as opposed to owning the physical assets, these are often called synthetic ETFs.

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[note 6] 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.[note 7]

The index manager reduces the tracking error of holding cash balances by buying a futures contract, or sometimes an exchange-traded fund (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.[20]

See also

Notes

  1. This page primarily concerns traditional market capitalization indexing. Indexes have been developed based on alternate weighting methodologies. See Alternate Indexes for an examination of these indexes.
  2. 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.
  3. Mid cap and small cap index funds have not been as efficient in providing qualified dividends to their investors. This may be due to the fact that these indexes have higher turnover than do the large cap indexes (qualified dividends have holding period requirements). Mid cap and small cap indexes also hold higher percentages of REITS, whose dividends are not qualified. See Percentages of REITs present in Vanguard index funds
  4. 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.
  5. A set of securities that shares a common feature such as the same market capitalization, industry or index. Universe Of Securities, from Investopedia
  6. "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 to the index.
  7. The latest number can be found at ICI - Monthly Trends in Mutual Fund Investing

References

  1. Investment Company Institute
  2. ICI 2015 Mutual Fund Factbook, Chapter Five
  3. William Bernstein, The Magic of Percentile Compounding, Efficient Frontier, April, 1999
  4. See Vanguard Passive Fund Brokerage Commissions for data
  5. W. Scott Simon, Index Mutual Funds, pp. 145-146. ISBN 0-9661172-7-1
  6. William Bernstein, How to Beat the Benchmark, Efficient Frontier, September 1998
  7. William Bernstein, Selection Skill, Transaction Skill, Efficient Frontier, Fall, 2000
  8. Robert H. Jeffrey and Robert D. Arnott, Is Your Alpha Big Enough To Cover Its Taxes?, 1993 • First Quadrant Corporation • No. 2
  9. See Vanguard accounting data spreadsheets for the tax data on Vanguard Index funds
  10. ICI 2009 Mutual Fund Factbook p.66
  11. Elton, Edwin J., Busse, Jeffrey A. and Gruber, Martin J., Are Investors Rational? Choices Among Index Funds (June 2002). NYU Working Paper; SSRN
  12. Petajisto, Antti, The Index Premium and its Hidden Cost for Index Funds (August 18, 2008); SSRN
  13. The Trade News, Understanding index front running
  14. Bogleheads® forum post: Re: Bloomberg - "The Hugely Profitable, Wholly Legal Way to Game the Stock Market"
  15. William Bernstein, Selection Skill, Transaction Skill, Efficient Frontier, Fall, 2000
  16. The 1940 Investment Company Act
  17. William Bernstein, Mea Culpa, Efficient Frontier, September 2005
  18. W. Scott Simon, Index Mutual Funds, p. 139. ISBN 0-9661172-7-1
  19. W. Scott Simon, Index Mutual Funds, pp. 139-140. ISBN 0-9661172-7-1
  20. W. Scott Simon, Index Mutual Funds, pp. 144-145. ISBN 0-9661172-7-1

External links

Bibliography