An index fund (also index tracker) is a mutual fund or exchange-traded fund (ETF) designed to follow certain preset rules so that the fund can track a specified basket of underlying investments. Those rules may include tracking prominent indexes like the S&P 500 or the Dow Jones Industrial Average or 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 fund’s 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 by S&P Dow Jones Indices for their S&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 markets or Frontier Market countries. 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.
The main advantage of index funds for investors is they don’t require a lot of time to manage as the investors don’t 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.
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.
The first theoretical model for an index fund was suggested in 1960 by Edward Renshaw and Paul Feldstein, both students at the University 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.
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 the SEC on 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 Malkiel wrote A 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 can’t buy the averages.” It’s 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.
John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: “The Economic Role of the Investment Company”. Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson‘s 1974 paper, “Challenge to Judgment”; Charles Ellis‘ 1975 study, “The Loser’s Game”; and Al Ehrbar’s 1975 Fortune magazinearticle on indexing. Bogle founded The Vanguard Group in 1974; as of 2009, it was the largest mutual fund company in the United States.
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 “Bogle’s folly”. Fidelity Investments Chairman Edward Johnson was quoted as saying that he “[couldn’t] believe that the great mass of investors are going to be satisfied with receiving just average returns”. Bogle’s fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor’s 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 market’s increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000.
John McQuown and David G. Booth of Wells Fargo, and Rex Sinquefield of the American National Bank in Chicago, established the first two Standard and Poor’s 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, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1971, Jeremy Grantham and 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.”
In 1981, Booth and Sinquefield started Dimensional Fund Advisors (DFA), and McQuown joined its Board of Directors many years later. DFA further developed indexed-based investment strategies. Vanguard started its first bond index fund in 1986.
Frederick L. A. Grauer at Wells Fargo harnessed McQuown and Booth’s indexing theories, which led to Wells Fargo’s pension funds managing over $69 billion in 1989 and over $565 billion in 1998. In 1996, Wells Fargo sold its indexing operation to Barclays Bank of London, which it operated under the name Barclays Global Investors (BGI). Blackrock, Inc. acquired BGI in 2009; the acquisition included BGI’s index fund management (both its institutional funds and its iShares ETF business) and its active management.
Economist Eugene Fama said, “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. A 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. Economists cite the efficient-market hypothesis (EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies that fund managers and 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. By 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 the ex-anteexpectation; ex-post realisation of payoffs may make some stock-pickers appear successful. In addition, there have been many criticisms of the EMH.