Index Fund Investing

Index investing—or indexing—is a form of passive investing in which a portfolio is invested to mirror a specific benchmark portfolio, called the index. The portfolio’s holdings are generally maintained to be proportional to those of the index. There is no trading to enhance returns. The goal is to earn the same returns as the index, less expenses. Another way to think of index investing is that it is benchmarked active investing but without active bets.

Indexed investment funds are called index funds. Most index funds have equity indexes, with the S&P 500 a popular choice. There are also fixed income index funds. Index funds linked to other asset classes are less common.

Index funds are structured as commingled funds, mutual funds or exchange-traded funds (ETFs). Commingled funds are typical for institutional investors. Mutual funds and ETFs are suitable for retail investors. Management fees vary by provider and index. A commingled S&P 500 fund might cost as little as 3 basis points a year. A similar mutual fund might have an expense ratio of 15 basis points. At the time of writing, E*TRADE offers an S&P 500 mutual fund for 9 basis points. On the other hand, there are index mutual funds that charge exorbitant fees of unsuspecting investors, especially investors in defined contribution retirement funds, where investment alternatives are limited.

Funds can offset some or all their fees with income earned lending the fund’s securities. A controversial issue is the fact that some mutual fund companies (Vanguard is an exception) don’t return all securities lending income to the funds they run.[1]

Index funds were proposed as early as Renshaw and Feldstein (1960). Implementation was prompted by two subsequent finance theories. The first of these was Eugene Fama’s (1965) efficient market hypothesis, which suggests that, after trasaction costs, active investing will not outperform passive investing. The second theory was William Sharpe’s (1964) capital asset pricing model (CAPM). According to CAPM, investors can construct a super-efficient portfolio by holding positions in cash and the market portfolio. In practice, a broadly diversified index fund could serve as a proxy for the market portfolio.

Wells Fargo was a pioneer of index investing, launching the first index fund in 1971 with a $6 million investment from Samsonite Corporation’s pension fund. Wells Fargo offered a second commingled index fund open to all the bank’s trust clients in 1973. American National Bank offered a similar fund the same year. In 1974, Batterymarch Financial Managemen launched another.

Early interest in index investing grew slowly, but the 1973 publication of Burton Malkiel’s book A Random Walk Down Wall Street was influential. Articles by Samuelson (1974), Ellis (1975) and Ehrbar (1975) followed. In 1975, John Bogle launched the first indexed mutual fund. His fledgling fund company, the Vanguard Group, would become a powerhouse of index investing, growing to be one of the world’s largest mutual fund companies.[2]

While index funds do not trade to enhance returns, they do trade, incurring transaction costs. New investments, the reinvestment of income or withdrawals may prompt the purchase or sale of holdings. Changes in the index’s holdings or weightings can also necessitate trading. Wells Fargo’s first index fund had as its index an equal dollar investment in each of the approximately 1,500 stocks traded on the New York Stock Exchange. This was a terrible choice, as the portfolio required constant rebalancing due to price fluctuations of individual shares in the index. Wells Fargo’s second index fund used the S&P 500 as its index, but even that requires occasional trading as Standard & Poors changes the composition of the index.

For taxable investors, because index funds entail some turnover, a strict buy-and-hold strategy may afford better long-term after-tax performance. See Holton (1994).

In practice, index funds may not be fully invested in their index. Many hold modest cash positions in case of client withdrawals. They then use index futures to achieve index exposure proportional to those cash positions. In this way, the funds can maintain cash positions while still closely tracking their indexe.