How does indexing work?
For the average investor, indexing involves:
· Picking indexes that provide the right mix of return and risk for their situation
· Picking funds that follow those indexes.
Index investors are content with the average performance of a market. They are skeptical that a money manager can improve on the average performance without raising risk. They are even more skeptical after hefty fees are subtracted.
Theoretically, an index can be created to track any publicly tradable asset worthy of investment. Index funds exist for a broad range of asset classes, including short, intermediate, and long-term bonds; U.S. large and small company stocks; value (low price relative to earnings) and growth (high price relative to earnings) stocks; international large and small company stocks; emerging market stocks, and others. In practice, most index investing involves common stocks and a majority of that centers around the S&P 500 Index.
Lower management fees make this a near mathematical certainty that a fund tracking an index will outperform actively managed investors seeking to beat that index. Why? By definition the average performance of investors in a certain type of asset is equal to the index of that asset type, before fees. So:
Average active investment return before fees = Index fund return before fees
Then fees are considered. Index funds almost always have lower fees than stockpicking funds, usually by 1% to 2% per year. So the equation is:
Index fund after fees = Average active investment return + (1% to 2%)
It turns out that the average index funds outperforms stockpicking funds which target the same markets by about the same amount as the difference in fees, year in and year out.
Average active investment return before fees = Index fund return before fees
Then fees are considered. Index funds almost always have lower fees than stockpicking funds, usually by 1% to 2% per year. So the equation is:
Index fund after fees = Average active investment return + (1% to 2%)
It turns out that the average index funds outperforms stockpicking funds which target the same markets by about the same amount as the difference in fees, year in and year out.
Index funds can be managed by a small staff. A personal computer can calculate at minimal expense how much to buy or sell of each stock when money flows in or out of an index fund. There is no need to pay a "star" manager with a strong track record to choose winning stocks. And typically index funds spends far less money on advertising to promote their record than firms with "star" managers.
Indexing guarantees that an investor's money will be spread over the entire market. Mutual funds or individual investors who pick stocks generally restrict themselves to a limited number of stocks so they can devote sufficient time to each.
Capital gains taxes are delayed because the index mutual fund buys and holds stocks longer than active funds that buy and sell stocks in hopes of outperforming the market. A stock is sold by the index fund only made if a company is removed from an index or investors request their money back. Because money that would have been paid out as taxes can keep producing investment returns, the effect of delaying taxes is powerful over time.
Since operating an index mutual fund involves no decision making, there is little for an investor to supervise. Indexing eliminates the risks, costs, and uncertainties of "active" management (stock picking and market timing). Index investors tend to sleep easier at night.
Funds may track very different indexes. Some indexes (eg, the S&P 500) are set up to measure the performance of large companies. Other indexes focus on small companies (the Russell 2000 being one of the most famous small-cap indexes), international stocks (MSCI-EAFE), and bonds (Lehman-Brothers Aggregate Bond). In addition, some indexes incur smaller fees. In some cases minor differences can occur from different trading costs in efforts to buy or sell stocks for indexing purposes.
Over the long term the S&P 500 index has beaten about 65-80% of mutual funds, depending on the time period. This is especially true when one takes into account "survivorship" bias. This bias occurs because the worst performing funds typically go out of business and are not counted in long-term records. Thus long-term performance of surviving funds to be higher than the sum of annual performances. Many fund groups "seed" numerous funds with small amounts of money precisely in order to weed out poor performers and to promote the "star" funds.
These funds try to mimic a chosen index. Examples of indices include the S&P 500, NASDAQ, and the Russell 2000. An index is simply a group of stocks chosen to represent a particular segment of the market. Usually this is accomplished by purchasing small amounts of each stock in a market.
Index funds are a hands-off approach to investing. The manager is not trying to find the hot stocks or great deals. Instead, the manager is simply trying to match an chosen index. The results are funds that are very cost efficient, meaning the operating costs are very low, and often beat most actively managed funds.
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