On Index Funds
As part of our financial weekly column I shall be collating a series of articles and facts that I have gleamed through the internet about, and crystallize the content in posts like this. Today, our first post will be on Index Funds.
What is an index fund?
An “index fund”, as described clearly on the US Security Exchange website , describes a type of mutual fund or unit investment trust (UIT) whose investment objective typically is to achieve approximately the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index or the Wilshire 5000 Total Market Index. An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in a selected index. Some index funds may also use derivatives (such as options or futures) to help achieve their investment objective. Some index funds invest in all of the companies included in an index; other index funds invest in a representative sample of the companies included in an index.
The management of index funds is more “passive” than the management of non-index funds, because an index fund manager only needs to track a relatively fixed index of securities. This usually translates into less trading of the fund’s portfolio, more favorable income tax consequences (lower realized capital gains), and lower fees and expensesthan more actively managed funds.
Because the investment objectives, policies and strategies of an index fund require it to purchase primarily the securities contained in an index, the fund will be subject to the same general risks as the securities that are contained in the index. Those general risks are discussed in the descriptions of stock funds and bond funds. In addition, because an index fund tracks the securities on a particular index, it may have less flexibility than a non-index fund to react to price declines in the securities contained in the index.
Why Index funds?
Investing in an index fund is a form of passive investing. The primary advantage to such a strategy is the lower management expense ratio on an index fund. Also, a majority of mutual funds fail to beat broad indexes, such as the S&P 500.
The reason for failure of the mutual fund is mainly down to psychology. Psychologists have long shown that humans have an inborn tendency to believe that the long run can be predicted from even a short series of outcomes. What’s more, when we see how skill, brains and hard work are rewarded, we have a tendency to think that such things will continue. Transpose this to stocks, and we realize that our intuition leads us to believe that funds that beat the market will continue to beat the market.
As Jason Zweig notes in his commentary on the late investment guru Benjamin Graham’s classic The Intelligent Investor, financial scholars have been studying mutual fund performance for at least half a century, and they are virtually unanimous on several points:
- The average fund does not pick stocks well enough to overcome the costs of researching and trading them;
- The higher the fund’s expenses, the lower its returns;
- The more frequently the fund trades its stocks, the less it tends to earn
While I do not believe that such statistics mean that all investors should just passively invest in stocks, I would still recommend that the average layman invest his or her stocks in funds that track the index instead of trying to beat the market.
And on that note, I shall end off with Benjamin Graham’s quote in the book that I really love:
“ … But note this important fact: The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent it suites his hole, and no more. Thus the investor who points himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off his stocks had no market quotation at all, for her would then be spared the mental anguish caused him by other person’s mistakes of judgement.”