collage of money, charts, student working and graduating

Efficient Indexing

The debate between the believers of index investing and the supporters of active investment management continues.  My guess is that this debate will never cease.  We do find that that index investing outperforms the majority of money managers, when markets are generally rising, and that the expense ratio of index mutual funds are quite low, as there is little for the manager of a pure index fund to do, except buy what is in the index .  Indexing also allows the investor immediate diversification and reduces the potential for style-drift that can effect active managers’ pursuit of returns.

Indexing has been around since the 1970s, when Wells Fargo and American National Bank established the Standard and Poor’s Composite Index funds for their institutional clients.  Later, one of the strongest proponents of index investing, John Bogle, founder of Vanguard Mutual Funds, started the First Index Investment Trust in 1975.  Moreover, index investing has been widely supported by research such as Malkiel’s, A Random Walk Down Wall Street (1973) and Ellis’ The Loser’s Game (1975). Yet, there are some aspects of indexing that we would like our readers to know.

Traditional indexing is where the money manager simply buys what is in the index, in accordance with the standards of the index.  For example, if the index is the Standard and Poor’s 500, a value-weighted index, the manager simply buys the stocks in the index in the same proportion as their equity value is represented in the index.  If, for example, the value of one large firm makes up 1% of the index, then 1% of the index’s funds will be invested in that firm.   Moreover, traditional indexing requires that each firm in the index be purchased, regardless of the quality or financial strength of the firm.  (It is indexing, not analysis.)

Synthetic indexing mimics an index through the purchase of derivative products, such as equity index futures, and low risk bonds to replicate the performance of a similar investment in all the equities in the index.  This is similar to enhanced indexing, where index fund management is “improved” by trying to generate slightly greater returns by employing strategies to fund management.  Popular strategies include a) constructing a proprietary index rather than one designed by a third-party, b) trading algorithms where elements are traded to enhance returns, c) tax strategies where elements are bought and sold to reduce taxes, and d) excluding certain investments that do not meet the standards of the index, such as firms with excessive debt, in bankruptcy, or facing a particularly volatile period in their history.

A growing segment of the market for indexing products are Exchange Traded Funds (ETFs) that are bought and sold on the major stock exchanges, similar to the common stocks of corporations.   Recently, Schwab, Vanguard and Fidelity have both instituted policies where those that have accounts with them do not pay commissions when purchasing their proprietary ETFs, while commissions are charged on the ETFs of other firms.  As an example, the Schwab U.S. Large-Cap ETFTM can be purchased in a Schwab account for $0 in commissions with an annual expense ratio, as of 1 July 2010, of 0.08%.  Moreover, each of these companies have Treasury bond ETFs; multiple domestic equity ETFs, including large–cap, small-cap, as well as those oriented toward growth and value; and several international ETFs.

The bottom line is that for small investors to find financial success, it is hard to beat the appeal of index investing, as long as the investor remains well diversified across asset classes and remains committed to their plan through both up and down markets.  If you can manage your emotions, while managing your money, the appeal of a self-directed index mutual fund or ETF portfolio is real.