Zaks Investment Advisory Service

Index Funds: Efficiency; Different Types of Index Funds

We were sidetracked in our two previous programs by current events: first, with the passing of Boris Nikolayevich Yeltsin, Russia’s first president, we discussed his economic policies; then, as the Dow Jones set another record, we decided to see how significant these records were in a historical perspective. But before then, we started talking about Index Funds, mostly funds that were created on the basis of the S&P 500. We talked about how fund managers have learned to build these funds based on the market weights of their corresponding shares, and also how Index Fund returns are, on average, no worse than those of “regular” actively managed funds. We tried to explain why this was the case. By the way, if you missed that program, you may find it on our site, www.zaksinvest.com.

So how do Index Fund returns compare to active ones? The Standard and Poor’s company, which by the way invented a series of indexes by the same name (we mentioned one of them – the S&P 500, but there are many others as well), tracks how Index Fund results compare to those of active funds. (You may find the relevant document in the Articles section of our site.) According to data published by Standard and Poor’s, over the past three years, the S&P 500 index outperformed 62 percent of all active funds investing in large companies (i.e. the types of companies whose shares make up the S&P 500 index). And the S&P 500 index outperformed 65 percent of those same funds over a five-year span. In other words, most actively managed funds return less money than the indexes. This is a fairly surprising result: we pay money to fund managers, and most of them cannot even match the returns of investors in passive, Index Funds! You could say: yes, but 30-something percent still managed to outperform the market. This is true, but the problem is, how are we supposed to find these funds? The thing is that active Mutual Funds’ returns are not consistent: they may be ahead of the market one year and fall behind the next. Just because a certain fund outperformed the market this year in no way guarantees it will do so the next! By the way, our site features an interesting article on this subject, with graphics illustrating the spreads of Mutual Fund returns. You can read it here.

So how to account for such unimpressive performance results by active Mutual Fund? As I mentioned in our previous program, it is explained by two factors: first, investment managers, analysts and brokers are far less capable of identifying fast-growing stocks than advertised. Their ability to do so, if one may speak frankly, is quite average – in the direct sense of the word: they could hit, they could miss, but on average they are no better than the market. Second, in addition to this, they charge fairly large sums of money to cover their expenses. If these expenses are deducted from the average results, then these come out worse than the average – which is what Standard and Poor’s confirmed.

So far, when we talked about indexes, we mostly meant the S&P 500. In reality, there are lots of different indexes – and corresponding Index Funds. For example, besides the famed S&P 500, Standard and Poor’s also has the S&P 400 MidCap and the S&P 600 SmallCap indexes. The S&P 400 is an index comprised of 400 companies that in terms of capitalization (i.e. the market value of all their shares) come directly after the 500 largest companies. In other words, the 500 largest get into the S&P 500, and the next 400 – into the S&P 400. This index is frequently called the MidCap: “Mid” for mid-sized, and “Cap” for capitalization. Funds than imitate this index offer people an effective opportunity for investing money in mid-sized companies. The next 600 companies make up the S&P 600 index, the so-called SmallCap index, i.e. an index of small companies. We have already mentioned that smaller companies, on average, bring better returns than larger ones (but are riskier at the same time), which is why many people invest in funds that imitate the S&P 600. By the way, I would like to clarify that these so-called small companies are not really that small. The largest company in the S&P 600 index has a capitalization of about $4.5 billion; i.e. the total market value of all its shares costs $4.5 billion. On average, their capitalization is slightly more than one billion dollars. Note that these indexes are made up of companies regardless of which markets they trade on: whether it be the New York Stock Exchange, the American Exchange, or NASDAQ. Most large companies’ shares trade on the New York Stock Exchange, but there are numerous exceptions: shares of such giants as Microsoft, Intel and Google, for example, are all trade on NASDAQ. As I have already said, there are many different Index Funds imitating the above-mentioned indexes.

Also worth mentioning are the so-called Exchange Traded Funds (ETFs), instruments that are very similar to Mutual Funds, except for certain specific distinctions. They may sometimes be more efficient than Mutual Funds. The number of ETFs is growing constantly, and right now there are about 500 of them. We will definitely have a separate discussion about them.

And with that, we will have to conclude for the day. This was Sergey Zaks. Thank you for your attention and until next time.