3/31/17

The Opportunities and Challenges of Index Investing

In the late 1800s, Charles Dow, the father of the Dow Jones Industrial Average, originally set out to measure market trends and forecast market movements through the creation of the world’s first index. His focus was particularly in the industrial sector, which he believed was “destined to be the great speculative market of the United States.”

Over time, however, indexes like Dow’s became publicly available as investable mutual funds. In 1976, Vanguard founder John Bogle launched the first index mutual fund, the Vanguard Index Trust (now the Vanguard 500 Index Fund), which tracks the S&P 500 index and remains one of the most popular index funds still today.

Index Investing: Opportunities and Benefits

The birth of index funds paved the way for an entirely new way to invest. Instead of attempting to outperform the market through active management and speculative strategies, buy-and-hold index funds offer a lower-cost alternative based on sensibly capturing long-term market returns. Since the securities within the index funds align exactly with those in a particular index, these passively managed funds do not require high fees to manage, keeping costs passed along to individual investors low.

Because index funds are generally invested in a diverse portfolio of companies or bonds, they also lend themselves well to two other key pillars of sound investing: diversification, how well your portfolio represents a broad spectrum of market asset classes, and asset allocation, how your portfolio is divided among stocks, bonds and other investments.  

Index Investing: Challenges and Shortfalls

Despite the benefits of index investing, there is room for improvement. For example, when an index restructures, so too must the index fund. This can create a less-than-preferable “buy high, sell low” environment as index fund managers work quickly to re-arrange the underlying stocks in their fund to match the index it is intended to track.

Also, despite your best efforts to allocate assets appropriately, you must keep a watchful eye on the underlying asset classes the index fund tracks to understand your portfolio’s true composition. For example, both the S&P 500 and Russell 3000 generally track the U.S. stock market; however, both also track real estate. If you don’t factor that into your portfolio composition, you may tip the balance of your portfolio toward real estate investments without knowing it.

Evidence or Research-Based Investment Funds

One offshoot of index investing, called evidence-based investing, builds on the theory of index investing as a foundation, but attempts to address some of its shortfalls. Evidence-based investing places the emphasis on the asset class that an index is rooted in rather than perfectly tracking an index itself. Evidence-based fund managers invest in securities within asset classes themselves, which eliminates the need to place unnecessary trades at inopportune times just to track an index perfectly at all times.  

Evidence-based investing also lessens the possibility of erroneously tipping your portfolio’s composition because it focuses on the asset classes that underlie the indexes, not the indexes themselves. This style of investing also allows fund managers to pinpoint and control portfolio allocation more precisely according to investors’ risk tolerance and return goals.

Indexes – like your investments – evolve over time. While they serve as valuable tools to track market segments and can play an important role in your long-term investment strategy, they do not foretell what the future holds and can always be improved.

By understanding the history of index and evidence based funds , how they are constructed, and how they have evolved over time through research, we hope you can now better understand the value of them at work in your portfolio.

 

The FMB Blog

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