An index fund or index tracker is a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions. This article deals with U.S. mutual funds. ... An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ... A comparison of three major stock indices: the NASDAQ Composite, Dow Jones Industrial Average, and S&P 500. ...

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 to purchase and is therefore a form of passive management. For security (collateral), the legal right given to a creditor by a borrower, see security interest A security is a fungible, negotiable instrument representing financial value. ... Passive management (also called passive investing) is a financial strategy in which a fund manager makes as few portfolio decisions as possible, in order to minimize transaction costs, including the incidence of capital gains tax. ...

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'. Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a benchmark index. ...

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 [1]. Investment management, the professional management of various securities (shares, bonds etc) and other assets (e. ... The S&P 500 is an index containing the stocks of 500 Large-Cap corporations, most of which are American. ... The Dow Jones Wilshire 5000 Total Stock Market Index, also known as the Dow Jones Wilshire 5000 Composite Index or simply the Wilshire 5000 is a broad base stock market index often used to represent the entire United States stock market. ... The Financial Times Stock Exchange Index of 100 Leading Shares, or FTSE 100 Index (pronounced footsie), is a share index of the 100 largest companies listed on the London Stock Exchange. ... The FTSE All-Share Index is a capitalisation-weighted index, comprised of companies traded on the London Stock Exchange. ... Eugene F. Fama. ... Kenneth R. French (born March 10, 1954) is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business, Dartmouth College. ... Eugene F. Fama. ... Dimensional Fund Advisors is an investment firm that develops mutual funds grounded in academic research. ... Jeremy Siegel Jeremy Siegel (born November 14, 1945) is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania in Philadelphia, Pennsylvania. ... A dividend is the distribution of profits to a companys shareholders. ... Income, generally defined, is the money that is received as a result of the normal business activities of an individual or a business. ... The book value of an asset or group of assets is sometimes the price at which they were originally acquired (historic cost), in many cases equal to purchase price. ... Sales are the activities involved in providing products or services in return for money or other compensation. ...

Origins of the index fund

In 1973, Burton Malkiel published his book A Random Walk Down Wall Street, which presented academic findings for the lay public. It was becoming well-known in the lay financial press that most mutual funds were not beating the market indices, to which the standard reply was made "of course, you can't buy an index." Malkiel said, "It's time the public can." Burton Gordon Malkiel (born August 28, 1932) is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street (now in its 8th edition, 2003). ... To meet Wikipedias quality standards, this article or section may require cleanup. ...

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. John C. (Jack) Bogle (b. ... Princeton University is a private coeducational research university located in Princeton, New Jersey. ... Paul Anthony Samuelson (born May 15, 1915, in Gary, Indiana) is an American neoclassical economist known for his contributions to many fields of economics, beginning with his general statement of the comparative statics method in his 1947 book Foundations of Economic Analysis. ... Charles Ellis is a deceased U.S. soccer midfielder who is best known for scoring a goal in each of the U.S. national teams first two games. ... Vanguard is a United States investment management company that offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. ... Year 2005 (MMV) was a common year starting on Saturday (link displays full calendar) of the Gregorian calendar. ...

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"^[1]. 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^[2]". 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. is the 365th day of the year (366th in leap years) in the Gregorian calendar. ... Year 1975 (MCMLXXV) was a common year starting on Wednesday (link will display full calendar) of the Gregorian calendar. ... Fidelity Investments is a group of privately held companies in the financial services industry. ... The S&P 500 is an index containing the stocks of 500 Large-Cap corporations, most of which are American. ... Fidelity Magellan Fund (FMAGX) The Magellan fund is perhaps the world’s best known actively managed mutual fund. ...

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. An older Wells Fargo branch, located in Berkeley, California Wells Fargos corporate headquarters and main branch Wells Fargo & Co. ... Rex Sinquefield is the co-founder and co-chairman of Dimensional Fund Advisors. ... For other banks with a similar name, see First American 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). Dimensional Fund Advisors is an investment firm that develops mutual funds grounded in academic research. ...

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. Barclays Global Investors is a division of British based Barclays Bank which specialises in asset management. ... 2005 is a common year starting on Saturday of the Gregorian calendar. ...

Economic theory

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 (Grossman and Stiglitz (1980))." 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 (Jensen (1978)). Economists cite the efficient market hypothesis 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.^[3] By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided. Eugene F. Fama. ... In finance, the efficient market hypothesis (EMH) asserts that financial markets are informationally efficient, or that prices on traded assets, e. ... Investment management, also called asset management, fund management or portfolio management is the professional management of collective investments (including insurance and pension funds) to meet specified investment goals for the benefit of the investors. ...

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.

Indexing methods

Traditional indexing

Indexing is traditionally known as the practice of owning a representative collection of securities, in the same ratios as the target index. Modification of security holdings happens only when companies periodically enter or leave the target index. For security (collateral), the legal right given to a creditor by a borrower, see security interest A security is a fungible, negotiable instrument representing financial value. ...

Synthetic indexing

Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favourable tax treatment, particularly for international investors who are subject to U.S. dividend withholding taxes. The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing.

Enhanced indexing

Enhanced indexing is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using active management. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. The cost advantage of indexing could be reduced or eliminated by employing active management. Enhanced Indexing is a catch-all term to a list of modifications to index fund investing that emphasize on performance rather than market tracking. ... Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a benchmark index. ... Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a benchmark index. ...

Advantages

Low costs

Because the composition of a target index is a known quantity, it costs less to run an index fund. No highly paid stock pickers or analysts are needed. Typically expense ratios of an index fund ranges from 0.15% for U.S. Large Company Indexes to 0.97% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2005 is 1.36%. If a mutual fund produces 10% return before expenses, taking account of the expense ratio difference would result in an after expense return of 9.85% for the large cap index fund versus 8.64% for the actively managed large cap fund.

Simplicity

The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as rebalancing every six months or every year.

Lower turnovers

Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in capital gains tax charges, which are sometimes passed on to fund investors. Because index funds are passive investments, the turnovers are lower than actively managed funds. According to a study conducted by John Bogle over a sixteen-year period, investors get to keep only 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners.^{[citation needed]} For all other forms of taxation, see tax Tax rates around the world Tax revenue as % of GDP Economic policy Monetary policy Central bank   Money supply Fiscal policy Spending   Deficit   Debt Trade policy Tariff   Trade agreement Finance Financial market Financial market participants Corporate   Personal Public   Banking   Regulation        A capital gains... John C. (Jack) Bogle (b. ...

No Style Drift

Style drift occurs when actively managed mutual funds go outside of their described style (ie. mid-cap value, large cap income, etc) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.

Disadvantages

Possible tracking error from index

Since index funds aim to match market returns, both under and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market.

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.^[4] Vanguard is a United States investment management company that offers mutual funds and other financial products and services to individual and institutional investors in the United States and abroad. ... A basis point (often denoted as bp, bps or ; rarely, permyriad) is a unit that is equal to 1/100th of 1%. It is commonly used to denote the change in a financial instrument, or the difference (spread) between two interest rates; although it may be used in any case...

Cannot outperform the target index

By design, an index fund seeks to match rather than outperform the target index. Therefore, a good index fund with low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minus fund costs. In finance, rate of return (ROR) or return on investment (ROI), or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. ...

Not immune to market bubbles

Owning a diversified stock index fund does not make an investor immune to systematic risk (e.g., a stock market bubble).^[5] When the U.S. technology sector bubble burst in 2000, the S&P 500 dropped significantly. Diversification in finance involves spreading investments around into many types of investments, including stocks, mutual funds, bonds, and cash. ... A systemic risk is a risk faced by a system, in contrast to a specific risk or unique risk. ... A stock market bubble is a type of economic bubble taking place in stock markets when price of stocks rise and become overvalued by any measure of stock valuation. ... The S&P 500 is an index containing the stocks of 500 Large-Cap corporations, most of which are American. ...

Index composition changes reduce return

Whenever an index changes, the fund is faced with the prospect of selling all the stock that has been removed from the index, and purchasing the stock that was added to the index. The S&P 500 index has a typical turnover of between 1% and 9% per year.^[6]

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 over-all advantage gained by low costs. In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. ...

Diversification

Main article: Diversification (finance)

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.^[7] Diversification in finance involves spreading investments around into many types of investments, including stocks, mutual funds, bonds, and cash. ... Diversification in finance involves spreading investments around into many types of investments, including stocks, mutual funds, bonds, and cash. ... The Dow Jones Wilshire 5000 Total Stock Market Index, also known as the Dow Jones Wilshire 5000 Composite Index or simply the Wilshire 5000 is a broad base stock market index often used to represent the entire United States stock market. ... An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ...

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. The S&P 500 is an index containing the stocks of 500 Large-Cap corporations, most of which are American. ... The Financial Times Stock Exchange Index of 100 Leading Shares, or FTSE 100 Index (pronounced footsie), is a share index of the 100 largest companies listed on the London Stock Exchange. ... Volatility most frequently refers to the standard deviation of the change in value of a financial instrument with a specific time horizon. ... On ground of assurance of the return, there are two kinds of Investments - Riskless and Risky. ...

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 ^[8]. 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 and achieving balance

Main article: Asset allocation

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. Asset allocation A large part of financial planning is finding an asset allocation that is appropriate for a given person in terms of their appetite for and ability to shoulder risk. ... Asset allocation A large part of financial planning is finding an asset allocation that is appropriate for a given person in terms of their appetite for and ability to shoulder risk. ... For other uses, see stock (disambiguation). ... For alternative meanings, see bond (a disambiguation page). ...

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. An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ...

Comparison of index funds with index ETFs

Mutual funds are priced at end of day (4:00 pm), while index ETFs have intra-day pricing (9:30 am - 4:00 pm). An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ...

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. [2]. An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ...

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 [3], for example.

U.S. capital gains tax considerations

U.S. mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains.

Scenario: An investor entered a mutual fund during the middle of the year and experienced an over-all 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 over-all loss. Seal of the Internal Revenue Service Tax rates around the world Tax revenue as % of GDP Part of the Taxation series        IRS redirects here. ...

A small investor selling an ETF to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains. An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ... An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ... An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ...

See also

• Active management
• Exchange-traded fund
• List of finance topics
• Passive management
• Stock market index
• Enhanced indexing
• Value investing

Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming a benchmark index. ... An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. ... Topics in finance include: // Finance an overview Arbitrage Capital (economics) Capital asset pricing model Cash flow Cash flow matching Debt Default Consumer debt Debt consolidation Debt settlement Credit counseling Bankruptcy Debt diet Debt-snowball method Discounted cash flow Financial capital Funding Financial modeling Entrepreneur Entrepreneurship Fixed income analysis Gap financing... Passive management (also called passive investing) is a financial strategy in which a fund manager makes as few portfolio decisions as possible, in order to minimize transaction costs, including the incidence of capital gains tax. ... A comparison of three major stock indices: the NASDAQ Composite, Dow Jones Industrial Average, and S&P 500. ... Enhanced Indexing is a catch-all term to a list of modifications to index fund investing that emphasize on performance rather than market tracking. ... Value investing is a style of investment strategy from the so-called Graham & Dodd School. ...

References

The McGraw-Hill Companies, Inc. ... Year 2006 (MMVI) was a common year starting on Sunday of the Gregorian calendar. ... is the 356th day of the year (357th in leap years) in the Gregorian calendar. ... BusinessWeek is a business magazine published by McGraw-Hill. ... The McGraw-Hill Companies logo. ... Year 2004 (MMIV) was a leap year starting on Thursday of the Gregorian calendar. ... is the 109th day of the year (110th in leap years) in the Gregorian calendar. ... Year 2007 (MMVII) was a common year starting on Monday of the Gregorian calendar in the 21st century. ... is the 51st day of the year in the Gregorian calendar. ... Morningstar, Inc. ... Year 2006 (MMVI) was a common year starting on Sunday of the Gregorian calendar. ... is the 52nd day of the year in the Gregorian calendar. ... Year 2007 (MMVII) was a common year starting on Monday of the Gregorian calendar in the 21st century. ... is the 51st day of the year in the Gregorian calendar. ... Publications Standard & Poors publishes a weekly (48 times a year) stock market analysis newsletter called The Outlook, which is issued both in print and online to subscribers. ... Year 2007 (MMVII) was a common year starting on Monday of the Gregorian calendar in the 21st century. ... is the 51st day of the year in the Gregorian calendar. ... John C. (Jack) Bogle (b. ... Year 2004 (MMIV) was a leap year starting on Thursday of the Gregorian calendar. ... is the 103rd day of the year (104th in leap years) in the Gregorian calendar. ... Year 2007 (MMVII) was a common year starting on Monday of the Gregorian calendar in the 21st century. ... is the 51st day of the year in the Gregorian calendar. ... 2008 (MMVIII) is the current year, a leap year that started on Tuesday of the Anno Domini (or common era), in accordance to the Gregorian calendar. ... is the 8th day of the year in the Gregorian calendar. ... Berkshire Hathaway (NYSE: BRKA, NYSE: BRKB) is a conglomerate holding company headquartered in Omaha, Nebraska, U.S., that oversees and manages a number of subsidiary companies. ...

External links

• The best investment advice you'll never get San Francisco Magazine article about the history and practice of Index funds, with commentary on mutual funds
• Is Stock Picking Declining Around the World? The article argues that there is a move towards indexing.