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.

Index Fund History, Types, and Definitions Explained

In our last Indexes and Your Investments blog post, we reviewed what makes the most popular index funds rise above the rest and how the individual stocks in these popular index funds are selected. In this blog post, we’ll review some of the history behind index funds, as well as explore the many types of index funds that exist today.

The World’s First Index Fund

The world’s first index fund was the Dow Jones Average, which first appeared in media on July 3, 1884. The index fund was assembled to measure the overall performance of active companies and consisted of 11 commodity-based companies — nine of which were railroads. Although the Dow tracks more stocks today, it still uses the same methods as it did in 1884 to measure market performance and the number of stocks it tracks has remained the same since 1928.

Many criticize the Dow for its obstinate ways, including James Mackintosh, a senior market columnist for The Wall Street Journal, who said “It’s time to ditch the Dow. After 120 years, the venerable Dow Jones Industrial Average is an embarrassing anachronism, abandoned by professionals and beloved only be a media that mostly knows no better. It needs to be updated or, better, replaced.”

Despite its flaws, the Dow remains to this day one of the most popular index funds. Not all index funds are modeled like the Dow, however. There are many different ways to calculate and assemble index funds that we’ll explore in detail below.

What are the Different Types of Index Funds?

Index funds use many different methods to measure market performance. Here are a few ways index funds are calculated:

Price weighted: Price weighted index funds give more weight to stocks with higher share prices and lesser weight to stocks with lower share prices. The Dow is an example of an index fund that is price weighted.

Market cap weighted: This is the most common weighting system used. Market cap weighting multiplies a company’s share price by the total number of its outstanding shares, which gives more weight to the bigger, more influential companies in the market. Large cap stocks are typically those with a market cap of $10B or more, mid cap stocks are those with market caps between $2B and $10B, and small cap stocks are those with a market cap between $300,000 and $2B.

Equal weighted: As the name implies, each company’s stock carries equal weight, no matter how large or small the holding. In an equal-weighted version of the S&P 500, for example, each company’s stock carries 0.2% of the index’s total value.

Using different weighting systems, the same segment of the market can be measured many ways.

What companies are included in an index fund will also change how the market segment is measured. Index funds can contain a broad array of companies spanning several segments or a slim sliver of companies that adhere to certain rules within a narrow slice of the market. They can also include thousands of companies or just a few dozen.  Each of these characteristics can be thought of as a spectrum ranging from one extreme to another:

Highly representative: Some index funds rely on a select few securities to represent a large number of stocks. The Dow, for example, uses a mere 30 securities to represent thousands of U.S. stocks.

Widely inclusive: Other index funds include nearly all securities – both large and small — within a market segment to gauge the segment. The Wilshire 5000 Total Market Index, for example, contains all U.S. headquartered equities with available price data, covering a wide swath of the market.

Somewhere in between: Most index funds fall somewhere in between the spectrum, tracking a decent-sized number of the larger or hard-hitting companies, but not all of them. The S&P 500, which tracks around 500 publicly-traded U.S. securities, is an example of an index fund that falls somewhere in between.

As you can see, there are many variations of index funds used to measure market performance. The weighting system, number of securities, and types of securities within a fund can tilt the scale one way or another, reinforcing the claim in our first blog post that index funds are simply a model – not a perfect representation – of the market at any given time.