Tracking can be achieved by trying to hold all of the securities in the index, in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management.
The lack of active management (stock picking and market timing) usually gives the advantage of lower fees and lower taxes in taxable accounts. However, the fees will generally reduce the return to the investor relative to the index. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is known as the 'tracking error' or informally 'jitter'.
Index funds are available from many investment managers. Some common indices include the S&P 500, the Wilshire 5000, the FTSE 100 and the FTSE All-Share Index. Less common indexes come from academics like Eugene Fama and Kenneth French, who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The Fama French Three Factor model is used by Dimensional Fund Advisors to design their index funds. Robert Arnott and Professor Jeremy Siegel have also created new competing fundamentally based indexes based on such criteria as dividends, earnings, book value, and sales. Companies such as the Dow Jones publish a variety of global indexes as well, with index data online
John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." 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 magazine article on indexing. Bogle founded The Vanguard Group in 1974; it is now the second-largest mutual fund company in the United States as of 2005.
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 Booth at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first 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 1981, David Booth and Rex Sinquefield started Dimensional Fund Advisors (DFA), many years later McQuown joined its Board of Directors. DFA further developed indexed based investment strategies and currently has $150 billion under management (as of Oct. 2007).
Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclays Global Investors; it is one of the world's largest money managers with over $1.5 trillion under management as of 2005.
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 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.
According to The Vanguard Group, a well run S&P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar survey found an average of 38 basis points across all index funds.
In effect, the index, and consequently all funds tracking the index, are announcing ahead of time the trades that they are planning to make. As a result, the price of the stock that has been removed from the index tends to be driven down. The price of stock that has been added to the index tends to be driven up. The index fund, however, has suffered market impact costs because they had to sell stock whose price was depressed, and buy stock whose price was inflated. These losses are small, however, relative to an index fund's overall advantage gained by low costs.
Diversification refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not.
Since some indices, such as the S&P 500 and FTSE 100, are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.
Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization . A global indexing strategy may outperform one based only on home market indexes because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.
Asset allocation is the process of determining the mix of stocks, bonds and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low cost and tax efficient manner and are used to design balanced portfolios.
A combination of various index mutual funds or ETF's could be used to implement a full range of investment policies from low risk to high risk.
Some index ETFs have lower expense ratio as compared to regular index funds. Historically, however, ETFs have been subject to high brokerage fees. Recently though, online brokers have begun to reduce or eliminate these fees.
Many investors outside the US are able to purchase US based ETFs, but not US based mutual funds. If mutual funds in their home market are more expensive than US based ETFs, then purchasing ETFs may be the cheaper option. This is currently the case for Canadian investors , for example.
Scenario: An investor entered a mutual fund during the middle of the year and experienced an overall loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the overall loss.
"Database, Slip Data Management Server, and Index Data Management Program" in Patent Application Approval Process
Oct 04, 2012; By a News Reporter-Staff News Editor at Politics & Government Week -- A patent application by the inventors Akita, Toshifumi...