Index fund

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An index fund (also index tracker ) is a mutual fund or exchange-traded fund (ETF) designed to follow certain rules so that funds can track the specified base investment basket. These rules may include tracking prominent indices like S & amp; P 500 or Dow Jones Industrial Average or implementation rules, such as tax management, minimize tracking errors, large block trades or flexible/patient trading strategies that allow for larger tracking errors, but lower market impact costs. Index funds may also have rules that screen social and ongoing criteria.

The fund index construction rule clearly identifies the type of company that is suitable for the fund. The most common index fund known in the United States, the S & P 500 Index Fund, is based on rules set by the S & P Dow Jones Index for their S & P 500 Index. The equity index fund will include stock groups with similar characteristics such as the size, value, profitability and/or geographic location of the company. A stock group may include companies from the United States, Non-US Developed, emerging markets or Frontier Market countries. Additional index funds in this geographic market may include a company index that includes rules based on firm characteristics or factors, such as small, medium, large, small value, large value, small growth, large growth, gross profitability or investment capital, real estate , or indices based on commodities and fixed income. Companies are bought and held in index funds when they meet certain index rules or parameters and are sold when they move out of those rules or parameters. Think of index funds as an investment using rule-based investments. Some index providers announce company changes in their index before the date of change and other index providers make no such announcements.

The main advantage of index funds for investors is that they do not take much time to manage because investors do not have to spend time analyzing stocks or stock portfolios. Many investors also find it difficult to beat the performance of the S & P 500 Index because of the lack of experience/skills in investing.

One index provider, Dow Jones Indexes, has 130,000 indexes. Dow Jones Indexes says that all of its products are maintained in accordance with a clear, unbiased, and systematic methodology that is fully integrated within the index family.

In 2014, index funds comprise 20.2% of equity mutual fund assets in the US. The index of domestic equity funds and index-based exchange-based funds (ETFs), has benefited from a trend toward more index-oriented investment products. From 2007 to 2014, the index of domestic equity funds and ETFs received $ 1 trillion in new net cash, including reinvested dividends. The index-based domestic equity index has grown very rapidly, attracting almost twice the flow of domestic equity index funds since 2007. Conversely, the actively-managed domestic stock mutual funds have net outflows of $ 659 billion, including re-invested dividends, 2007 to 2014.

Video Index fund

Origins

The first theoretical model for index funds was suggested in 1960 by Edward Renshaw and Paul Feldstein, both students at the University of Chicago. While their idea for "Unmanaged Investment Company" got little support, it started a series of events in the 1960s that led to the creation of the first index fund within the next decade.

Qualidex Fund, Inc., a Florida Company, chartered on 05/23/1967 (317247) by Richard A. Beach (BSBA Banking and Finance, University of Florida, 1957) and joined Walton D. Dutcher Jr., filed for registration statement ( 2-38624) with the SEC on October 20, 1970 which became effective on July 31, 1972. "The fund is managed as a diversified and open investment company whose investment objective is to estimate the performance of Dow Jones Industrial Stocks, on average," with thus becoming the first index fund.

In 1973, Burton Malkiel wrote A Random Walk Down Wall Street , presenting academic findings for the common people. It became famous in the popular financial press that most mutual funds did not beat the market index. Malkiel writes:

What we need is a no-load, minimum cost management mutual fund that buys only hundreds of stocks that make up a broad stock market averages and does not trade from security to security in an attempt to capture the winners. Whenever performance below average on the part of each mutual fund is noticed, a quick fund spokesperson to show "you can not buy averages." It's time the public can.

... no greater services [New York Stock Exchange] can provide than sponsor such funds and run them on a nonprofit basis.... Such funds are urgently needed, and if the New York Stock Exchange (, incidentally has considered such a fund it) does not want to do it, I hope some other institutions will do it.

John Bogle graduated from Princeton University in 1951, in which his senior thesis entitled: "The Role of Investment Company Economy". Bogle writes that his inspiration for starting an index fund comes from three sources, all of which confirm his research in 1951: Paul Samuelson's 1974 paper, "Challenges for Judgment"; Charles Ellis's 1975 research, "The Loser's Game"; and magazine article 1975 Fortune on the indexing of Al Ehrbar. Bogle founded The Vanguard Group in 1974; in 2009, it is the largest mutual fund company in the United States.

Bogle started the First Index Investment Trust on December 31, 1975. At that time, it was heavily mocked by competitors as "un-American" and the funds themselves were seen as "Bogle's stupidity". Fidelity Investments Chairman Edward Johnson said that he "[can not] believe that a large mass of investors will be satisfied with just receiving average returns". The Bogle Fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with a relatively small asset of $ 11 million but crossed the $ 100 billion milestone in November 1999; this remarkable increase is being funded by an increasing market desire to invest in such products. Bogle estimates in January 1992 that it will likely surpass Dana Magellan before 2001, which occurred in 2000.

John McQuown and David G. Booth from Wells Fargo, and Rex Sinquefield of the American National Bank in Chicago, founded the first two Standard and Poor Composite Funds in 1973. Both funds were established for institutional clients; individual investors are issued. Wells Fargo started with $ 5 million from their own pension fund, while Illinois Bell put their $ 5 million in pension fund at the American National Bank. In 1971, Jeremy Grantham and Dean LeBaron at Batterymarch Financial Management "described the idea at the Harvard Business School seminar in 1971, but did not find any applicants until 1973. Two years later, in December 1974, the company finally withdrew its first index client. "

In 1981, Booth and Sinquefield started Dimensional Fund Advisors (DFA), and McQuown joined the Board of Directors a few years later. DFA further develops an index-based investment strategy. Vanguard started its first bond index fund in 1986.

Frederick LA Grauer at Wells Fargo capitalized on McQuown and Booth indexing theory, which led Wells Fargo's pension fund to manage more than $ 69 billion in 1989 and over $ 565 billion in 1998. In 1996, Wells Fargo sold its indexing operations to Barclays Bank of London, operated under the name Barclays Global Investors (BGI). Blackrock, Inc. acquired BGI in 2009; acquisitions including the BGI index fund management (both institutional funding and ETF iShares business) and active management.

Maps Index fund

Economic theory

Economist Eugene Fama said, "I take the hypothesis of market efficiency to a simple statement that the security price fully reflects all available information." The prerequisite for a strong version of this hypothesis is that information and trade costs, the cost of getting prices to reflect information, is always 0. The weaker and more economically reasonable version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of act on the information (profit to be made) does not exceed the marginal cost. Economists cite the efficient market hypothesis (EMH) as a fundamental premise justifying the creation of index funds. This hypothesis implies that investment managers and stock analysts are constantly looking for securities that can outperform markets; and that this competition is so effective that any new information about a company's luck will be quickly put into stock prices. It is therefore postulated that it is very difficult to say in the future which stocks will go out of the market. By creating an index fund that reflects the entire market, the inefficiency of stock selection is avoided.

In particular, EMH says that economic benefits can not be squeezed out of stock-taking. This is not to say that stock voters can not achieve superior returns, but the excess return will not exceed the cost to win it (including salary, information costs, and trade costs). The conclusion is that most investors would be better off buying cheap index funds. Note that refunds refer to ex-ante expectations; The realization of an ex-post payment can make some stock-pickers seem successful. In addition, there are many criticisms of EMH.

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Tracking

Tracking can be achieved by trying to hold all the securities in the index, in the same proportion as the index. Other methods include statistically sampling the market and holding "representative" securities. Much of the index funds depend on computer models with little or no human input in decisions about which securities are bought or sold and thus subject to a form of passive management.

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Cost

The lack of active management generally benefits from lower costs and, in taxable accounts, lower taxes. In addition it is usually not possible to accurately reflect the index because the model for sampling and reflection, by its nature, can not be 100% accurate. The difference between index performance and fund performance is called "tracking error", or, colloquially, "jitter."

Index funds are available from many investment managers. Some common indices include S & amp; P 500, Nikkei 225 and FTSE 100. Less common indices are from academics such as Eugene Fama and Kenneth French, who created the "research index" to develop asset pricing models, such as Three Factor Models. The Fama-French three-factor model is used by Dimension Fund Advisors to design their index funds. Robert Arnott and Professor Jeremy Siegel have also created new fundamentally-based indexes that compete based on criteria such as dividends, profits, book values, and sales.

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Indexing method

Traditional indexing

Traditional indexing

Indexing has traditionally been known as the practice of having a representative collection of securities, in the same ratio as the target index. Modification of security ownership occurs only when the company regularly enters or leaves the target index.

Synthetic indexing

Synthetic indexing is a modern technique using a combination of equity index futures and investments in low-risk bonds to replicate the performance of similar overall investments in the equity that make up the index. While maintaining a future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favorable tax treatment, especially for international investors subject to US dividend dividend taxes. Bond shares can have higher-yielding instruments, with a higher-risk trade-off, a technique called enhanced indexing.

Upgraded indexing

Improved indexing is a term that includes all that refers to improvements in index management of funds that emphasize performance, possibly using active management. Improved index funds use various upgrade techniques, including customized index (instead of relying on commercial index), trading strategies, exception rules, and timing strategies. The cost advantage of indexing can be reduced or eliminated by using active management. Improved indexing strategies help in offsetting the proportion of future tracking errors from transaction costs and costs. These upgrading strategies can be:

• lower cost, problem selection, yield curve position,
• sector and positioning and positioning of voice call positions.

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Advantages

Low cost

Since the composition of the target index is a known quantity, relative to actively managed funds, it costs less to run an index fund. The cost ratio is usually from the index fund range of 0.10% for the Large US Companies Index up 0.70% for the Emerging Markets Index. The average cap rate ratio that is actively managed by 2015 is 1.15%. If a mutual fund generates a 10% return before cost, taking into account the difference in cost ratio will result in a refund after 9.9% for large capitalization index funds versus 8.85% for large actively managed large capitalization funds.

Simplicity

The investment objective of index funds is easy to understand. Once an investor knows the target index of an index fund, what effect will be saved by index funds can be determined directly. Managing one's index funds can be as easy as rebalancing every six months or every year.

Lower

Turnover refers to the sale and purchase of securities by the investment manager. Selling securities in some jurisdictions can result in capital gains tax expense, which is sometimes passed on to investor funds. Even in the absence of taxes, the velocity has explicit and implicit costs, which directly reduce earnings based on dollars per dollar. Since index funds are a passive investment, turnover is lower than actively managed funds. According to a study conducted by John Bogle during a sixteen year period, investors can only save 47% of the cumulative return of an actively managed mutual fund, but they remain 87% in market index funds. This means $ 10,000 invested in index funds grew to $ 90,000 versus $ 49,000 in an actively managed average equity fund. That is a 40% profit from a silent partner reduction.

No floating style

Style drift occurs when actively managed mutual funds get out of the style described (ie, cap value limit, revenue with large caps, etc.) to increase returns. Such deterioration hurts portfolios built with diversification as a top priority. Drizzling to other styles can reduce the overall diversity of the portfolio and then increase the risk. With index funds, these irregularities are unlikely and accurate portfolio diversification increases.

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Disadvantages

Loss to arbitrage

Index funds should periodically "rebalance" or adjust their portfolios to adjust to new prices and market capitalization of underlying securities in shares or other indexes they track. This allows algorithmic traders (80% of the trades of which involve 20% of the most popular securities) to index arbitrage by anticipating and trading ahead of stock price movements caused by rebalancing of mutual funds, making gains over previous forecasts of large institutional block orders. This generates profits transferred from investors to algorithmic traders, estimated at least 21 to 28 basis points annually to S & P 500 index funds, and at least 38 to 77 basis points per year for Russell 2000 funds. As a result, the index, and consequently, all funds that track the index announce the previous trade they are planning, allow the value to be tapped by arbitration, in law & lt; sic & gt; a practice known as "index front running". The high-frequency traders of all algorithms have advanced access to index re-balancing information, and spend large amounts on fast technology to compete with each other to be first - often with a few microseconds - to make this arbitration.

John Montgomery at Bridgeway Capital Management says that the result of "return of poor investors" from trading in front of mutual funds is the "elephant in the room" which "surprisingly, people do not talk about." Related to "time zone arbitrage" against mutual funds and underlying securities traded in overseas markets is likely to "undermine financial integration between the United States, Asia and Europe."

Common market impact

One problem occurs when a large amount of money tracks the same index . According to theory, companies should not be worth more when they are in the index. However, due to supply and demand, the added company may experience a demand shock, and the company being removed can experience supply shocks, and this will change the price. This does not appear in tracking errors because the index is also affected. Funds may experience less impact by tracking less popular indexes.

Possible tracking errors from index

Because index funds aim to match market returns, neither performance below nor beyond the market is considered a "tracking error". For example, inefficient index funds can result in a positive tracking error in a falling market by holding too much cash, which holds value compared to the market.

According to The Vanguard Group, a well-managed S & P 500 index fund should have a tracking error of 5 basis points or less, but the Morningstar survey found averaging 38 basis points in all index funds.

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Diversification

Diversification refers to the amount of different securities in a fund. Funds with more securities are said to be more diversified than funds with smaller amounts of securities. Having multiple securities reduces volatility by reducing the impact of large price changes above or below average returns in one security. The Wilshire 5000 index will be considered to be diversified, but bio-tech ETF will not.

Because some indices, such as the S & P 500 and FTSE 100, are dominated by large corporate stocks, index funds may have a high percentage of funds concentrated in several large companies. This position represents a reduction in diversity and can lead to increased volatility and investment risk for investors seeking diversified funds.

Some advocates adopt an investment strategy in every security in the world in proportion to its market capitalization, generally by investing in ETF collections in proportion to the market capitalization of their home country. The global indexing strategy may have a lower return variant than those based solely on home market indices, since there may be less correlation between earnings of firms operating in different markets than between firms operating in the same market.

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Asset allocation and achieve balance

Asset allocation is the process of determining a mixture of stocks, bonds and other classes of investable assets to match investor risk capacity, which includes attitudes toward risk, net income, net worth, knowledge of investment concepts, and time horizons. Index funds capture asset classes with low cost and efficient tax ways and are used to design a balanced portfolio.

The combination of index funds or ETF mutual funds can be used to apply various investment policies from low risk to high risk.

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Pension investment in index funds

A study by the World Pensions Council (WPC) shows that up to 15% of all assets owned by large pension funds and national social security funds are invested in various forms of passive strategies including index funds - compared to more traditionally managed traditional mandates. which is still the largest part of institutional investment. The proportions invested in passive funds vary greatly between jurisdictions and types of funds

The relative attractiveness of index funds, ETFs and investment vehicles replicating other indices has grown rapidly for various reasons, ranging from disappointment with poorly performing mandates, to wider trends in cost reduction across public services and social benefits following the Great Recession 2008-2012.. Public sector pensions and national reserve funds have become one of the earliest adopters of index funding and other passive management strategies.

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Comparison of index funds with ETF index

In the United States, mutual funds price their assets at current value every business day, usually at 4:00 pm. Eastern Time, when the New York Stock Exchange closes for the day. The ETF index, on the other hand, is priced during normal trading hours, usually from 9:30 am to 4:00 pm. Eastern time. The ETF index is also sometimes weighed by income rather than market capitalization.

AS. consideration of capital gains tax

US mutual funds are required by law to distribute realized capital gains to their shareholders. If a mutual fund sells securities for profit, capital gains may be taxed for the year; as well as realized capital losses can offset other realized capital gains.

Scenario: An investor enters a mutual fund during the middle of the year and suffers an overall loss for the next 6 months. The mutual fund itself sells securities for profit for this year, therefore it should state the distribution of capital gains. The IRS will require investors to pay taxes on the distribution of capital gains, regardless of overall losses.

Small investors who sell ETFs to other investors do not cause redemption on the ETF itself; therefore, ETFs are more immune to the effects of forced redemption that lead to the realization of capital gains.

See also

• Exchange traded funds
• Passive management
• Stock market index
• Enhanced indexing

References

External links

• Is Stock Taken Down Worldwide? This article states that there is a step towards indexing.
• Fund Reduction Index Introduction to Investopedia Index Fund
• False Inventions in Mutual Fund Performance: Measuring Luck in Alpha Estimates Evidence that stock selection is not a viable investment strategy.
• Prescient Are Few -... "the amount of funds that have beaten the market throughout their entire history is so small that the False Discovery Rate test can not eliminate the possibility that some of the things done are just a positive error" - just lucky, in other words.
• The largest index fund in terms of managed assets

Source of the article : Wikipedia