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Index Funds: What Are They? Why Are They Growing?

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While 1975 may be the birth year of many notable people, it is also the birth of a sea change in mutual fund investing in America. Jack Bogle founded The Vanguard Group the year before and launched the first index fund for the masses, the Vanguard 500 Index fund.

Forty years later, this fund invests $152 billion into the components of the Standard & Poor’s 500 Index and Vanguard manages about $1 trillion in assets. Bogle’s company was literally the vanguard for the biggest investment trend in the world.

Appeal of Index Funds

Bogle attributes the development of index funds to the leading financial thinkers of the time. Eugene Fama had begun spreading the idea that the U.S. Stock Market was “efficient,” meaning it was very difficult for the typical investor to outperform the market, year-in and year-out (Fama recently won the Nobel Prize for this work). And Burton Malkiel published his seminal Random Walk Down Wall Street (now in its 10th edition) around this same time, calling for lower-cost investing options for individual investors. From this environment, the index fund emerged.

An index fund is a mutual fund, but it is considered “passively” managed. Instead of a group of people analyzing stocks and looking for winners to buy, an index fund buys everything in a given index. The Vanguard 500 fund buys every stock in the S&P 500, for example. Ideally, the fund’s performance closely matches the index’s performance, and the goal is for an investor to “buy the market.” Different funds use different indexes, and today’s investors have an index fund option for almost every investment category.

The benefits to this method of investing are two-fold.

First, it is incredibly cheap to run a fund where all the investment decisions are dictated by the index. For example, a typical index fund will have trades representing less than 30% of the fund’s value. A typical active fund, however, will trade more than 60% of its value in a year. The Investment Company Institute (ICI) recently estimated the average cost per year of owning an index fund at just $0.11 per $100; by comparison, its average estimates for traditional, actively managed funds are nearly eight times the cost at $0.86 per $100.

The cost difference leads to the second benefit of index funds. An active manager looking for good stocks to buy can’t just beat the market — she must also earn enough to cover the $0.86/$100 she charges every year.

Unfortunately, a recent S&P report (SPIVA) shows that more than 70% of active managers failed to beat their declared benchmark during the prior five years. Finding that other 30% is the chief problem faced by anyone investing in active mutual funds. Still, many people prefer the direct oversight of an experienced fund manager to the hands-off approach of an index fund.

Demand for Index Investing

Investors appear to demand the benefits outlined above. The ICI shows high growth in index investing. As of 2014, stock index investing represented $2 trillion in assets and had $148 billion in new investment.

In 2014, more than 20% of new equity mutual fund investment was in an index fund, compared to just 12% in 2004. More new money went into index fund strategies than actively managed mutual funds last year.

Impact on Markets

A rapid change in investor habits naturally has an impact on financial markets. One impact is on the trading patterns during the day. Index funds tend to trade near the end of the day, to invest any new cash flow and make sure they tracked the index’s result for that day as closely as possible. A recent Wall Street Journal article highlighted this behavior, showing how trade volume has shifted to the opening and closing half hour of each day. Fewer people trade in the middle of the day now, which means higher costs for those who do trade during these times.

A second impact has been on the investment firms. The demand for index investing has increased the supply of index opportunities in the market. There were 70 index funds in 1993, compared to 382 in 2014. This has been great for investors, as it has driven down the average costs of index funds even further, but it also makes these funds low margin offerings with little competitive advantage for any investment firm wanting to offer its own index product.

Individuals, Businesses

A typical investor may have an idea of what a mutual fund is, but choosing among funds can be complicated. To some degree, index funds have made it harder by adding even more choices.

Investors may get conflicting advice, too. Some advisers laud the low costs of index funds, while others pan the lack of direct oversight by an active fund manager. The current popularity suggests that investors should at least consider an index fund, and the widespread demand means businesses should at least have a few index funds in their 401(k) menus.

Evaluating index funds, fortunately, is easy. Funds following the same index invest the same, so the only thing that matters is the price. A good index fund option should clearly state the index it tracks and have very low expenses (e.g., an expense ratio of under 0.3% for domestic indexes). Most major investment firms offer several index funds options.

Jon Fulkerson is an assistant professor of finance for Loyola’s Sellinger School of Business, which has a campus in Columbia. He can be contacted at 410-617-5634 and jafulkerson@loyola.edu.