Zaks Investment Advisory Service

Index Funds: General Information

On Sunday, we held a seminar in the conference room of New Life Radio. It was attended by a surprisingly large audience and, I hope, was interesting and useful to all. During this seminar, I made several references to Index Funds, noting that they are comprised of stocks that, in the same proportion, make up indexes such as the S&P 500.

As opposed to regular fund managers, who spend their time analyzing and searching for stocks that, in their opinion, could perform especially well, Index Fund managers are content with copying existing indexes. This brings up a question: how could the slackers managing Index Funds (and these funds are called just that, “passively managed”) compete with regular, active funds? It seems to contradict all common sense. And immediately, another question comes to mind: which of these funds are better? Let us go through these questions one at a time.

Index Funds appeared a fairly long time ago, in the early 1970s. One of the first was an Index Fund launched by the Vanguard company. It was created by the famed investor John Bogle. At first, Index Fund managers simply tried to build portfolios out of stocks that make up the index: for example, the S&P 500 includes the companies 3M, Abbott, Alcoa, etc., and so they purchased 1,000 shares each of 3M, Abbott, Alcoa, etc., thus making up their Index Fund. But it soon became apparent that such funds are incredibly inefficient. You may remember that some time ago, when discussing risk, we tried to compare the risk and return of well-diversified and poorly-diversified portfolios. We mentioned that poorly-diversified portfolios were riskier (they had a greater variability of return), while failing to compensate by way of additional returns. Well, it turned out that the first Index Funds built from the same number of shares for each company were inefficient and, despite the large number of different stocks involved, poorly diversified. Fortunately, analysts soon figured out what was wrong and how to rectify the situation. It became clear that Index Funds should not be built from the same number of shares, but from a number of shares proportional to each company’s market weight. In practice, it is very inconvenient to use the “whole market” for these calculations, which is why the S&P 500 is used in its place. And there are good reasons for doing so: although the S&P 500 has only 500 of the several thousand companies traded on the US markets, the market value of all shares in its index represents about 80 percent of all shares traded in the United States. Which is why, quite often, when talking about the “whole market,” the financial world refers to the S&P 500 instead. So, after managers started building portfolios on a market-weighted basis, these became far more efficient, with results comparable to those of actively managed funds.

How could this be? The answer is based on two factors. The first is that, in reality, the active fund managers’ ability to pinpoint fast-growing stocks is very limited. Professor Burton Malkiel, a famous financial markets analyst, once wrote that if one were to pin a table of stock quotes from The Wall Street Journal to the wall, let a monkey throw a few darts at it and then select the stocks it hits, the resulting portfolio would perform no worse than a portfolio created by the most experienced Wall Street analyst. As far as I know, no one has ever actually performed the monkey experiment. But the idea that a market is efficient, in a sense that all of the information available about stocks is already incorporated into the stock price, and that there is little analysts could add to this, is one of the most basic in financial science. We will talk more about market efficiency at a later time, but if you are interested in reading some Malkiel, the Articles section of our site features one of his wonderful pieces. You may read it here.

The second reason why Index Funds often bring better returns than actively-managed ones is that they are usually much cheaper. We discussed Mutual Fund fees and expenses in one of our previous programs. Since Index Funds are passive, i.e. its managers do not have to keep up a constant search for new stocks, their expenses are very low. As I have already mentioned, expenses of the Vanguard group Index Fund are just 0.18 percent, while active funds sometimes charge as much as 2.5 percent.

These two factors – that active fund managers can rarely identify stock “winners,” but still charge fairly large fees for their work – result in Index Funds often outperforming active funds. The Standard and Poor’s company compiles a statistic comparing Index Fund performances to those of actively managed ones. We will discuss this, as well as the other types of Index Funds, in our next program.

Do you use Index Funds? Should you be? You should discuss these questions with your investment adviser. By the way, a couple of words about investment advisers: I was asked a lot of questions after the seminar, one of which was: how have my clients’ portfolios performed? I am not allowed to discuss client portfolios, and they are all different, but you may find a Portfolios page on my site. It features several models that are based on principles that I use in my work with clients. I think you may be interested in taking a look. All of the data are real and updated daily.

This was Sergey Zaks. Thank you for your attention and until next time.