Indexes such as Dow-Jones Index, Index Nasdaq, S&P 500 Index (Standard and Poor 500) and others are known as economic indicators and reflect the total shares’ value of all companies in the index (one share from each company). The indexes of the securities market were “invented” by Mr. Doe, a successful investor of the end of the 19th century. He used the amount of shares’ value while monitoring the stock market of railway companies. After his death, he left the notices with calculations, which shed light on the secrets of his success.
Statistics of growth of stock market indexes and investment funds reveals that only a small percentage of investment funds goes ahead of the indices. Based on statistics, various funds, which reflect market indexes, have emerged, and some experts recommend investors to work only with index funds. Their explanation is as follows: common managers can’t keep up with indexes, and the payment for the maintenance of the index fund (management fee) is much lower than the payment for the asset management of common funds.
Guidelines for investing in index funds typically come from people familiar with investing only superficially, or those trying different techniques to attract the public or customers. In practice, growth of index funds lags significantly behind growth of their “prototypes”. One can find a rather simple explanation of this fact: index funds incur costs which are peculiar to any of the investment funds and connected with business correspondence, advertising, costs of securities’ trading, accounting and preparation of audit reports. Indexes, which reflect the market behavior, have abstract value and don’t exist in real life.
Why do conventional funds usually grow better than the index funds? Let’s imagine a situation which is repeated several times every year: some companies are lagged behind their competitors and they are eased out of a certain index by an exchange decision. This becomes known about a week (or even a few months) before the lagging companies are excluded from the index formally. It comes naturally, that investors and fund managers start selling securities of these companies from their portfolios long before the decision takes effect. These securities weaken, and so do their reflecting index and index fund at the same time. Index-fund is obliged to sell these securities (their price has already fallen). Instead of companies emerged from the index the fund must buy new ones. Their list is announced a week or more before. Again, the purchase comes at overprices as investors and other funds have already bought these securities.
Now let us imagine the situation when the market is falling, and managers of conventional funds have an opportunity to get rid of the securities of the most risky companies. Index funds managers do not have such an opportunity.
Information: all the available funds in Canada count 5,573 (as of this writing), incorporating 162 index funds, that include 62 funds for which the management takes less than 1% per year; there are 12 funds out of them that have increased over the past 5 years, and these include 4 funds growing above the average for all funds during the last 10 years.
P.S.
Examples of the replacement of companies included into the index can be found here.
Michael Arbetov, CFP, FMA
Russian version of the article Index funds: myths and reality (were published on Mar 13, 2004)
In Jul 2011 Investment Funds Institute of Canada (IFIC) published a research Active and Passive Investing Strategies.