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FOUNDATIONS OF INDEX FUNDS The Efficient Market Theory is fundamental to the creation of the index funds. The idea is that fund managers and stock analysts are constantly looking for securities that would out-perform the market. The competition is so effective that any new information about the fortune of a company will translate into movements of the stock price almost instantly. It is very difficult to tell ahead of time whether a certain stock will out-perform the market. If one cannot beat the market, then the next best thing is to cover all bases: owning all of the securities, or a representative sampling of the securities available on the market. Thus the index fund concept is born. LOW COSTS OF INDEX FUNDS Because the composition of a target index is a known quantity, it costs less to run an index fund. No stock analysts need to be hired. Typically the Expense Ratio of an index fund is below 0.2%. The expense ratio of the average mutual fund As Of 2002 is 1.36% {Link without Title} . If a fund produces 7% return before expense, taking account of the expense ratio difference would result in after expense return of 6.8% versus 5.64%. SIMPLICITY The investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, what securities the index fund will hold can be determined directly. Managing one's index fund holdings may be as easy as Rebalancing every six months or every year. LOWER TURNOVERS Turnover refers to the selling and buying securities by the fund manager. Selling securities may result in Capital Gains Tax , which would be passed on to fund investors. Because index funds are passive investments, the turnovers are lower than actively managed funds. The management consulting firm Plexus Group estimated in 1998 that for every 100% turnover rate, a fund would incur trading expense at 1.16% of total asset. {Link without Title} DIVERSIFICATION Diversification refers to the number of different securities in a fund. A fund with more numbers of securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces the impact of a single security performing very below average. A Wilshire 5000 index would be considered diversified, but a bio-tech ETF would not. {Link without Title} While an index like the were allowed to weaken. ASSET ALLOCATION AND ACHIEVING BALANCE See Also: Asset allocation The topic of Asset Allocation is the process of determining the mix of Stocks , Bonds and other classes of investable assets that would result in an optimal combination of expected risk and return matching the investor's appetite for and capacity to shoulder risk. A combination of various index mutual funds or ETF's may be used to implement such an investment policy whilst minimising administration costs. COMPARISON OF INDEX FUND VERSUS INDEX ETF Index funds are priced at end of day (4:00 pm), while index ETFs have intra-day pricing (9:30 am - 4:00 pm). Some index ETFs have lower expense ratio as compared to regular index funds. However, brokerage expenses of index ETFs should not be over-looked. Capital gains distribution Mutual funds are required by law to distribute realized capital gains to their shareholders. If a Mutual fund sells a security for a gain, the capital gain is taxable for that year; similarly a realized capital loss can offset any other realized capital gains. Scenario: An investor entered a mutual fund during the middle of the year and experienced an over-all loss for the next 6 months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The IRS would require the investor to pay tax on the capital gains distribution, regardless of the over-all loss. A small investor selling an ETF to another investor does not cause a redemption on ETF itself; therefore, ETFs are more immune to the effect of forced redemptions causing realized capital gains. DISADVANTAGES OF INDEX FUNDS Since index funds achieve market returns, there is no chance of out-performing the market. On the other hand, it should not under-perform the market significantly. Investors should remember after all expenses and fees are subtracted their Rate Of Return will not exactly be the market return of the index; however, it should be very close. Owning a broad-based stock index fund does not make an investor immune to the effect of a Stock Market Bubble . {Link without Title} When the US technology sector bubble burst in 2000, the general stock market dropped significantly, and did not recover until 2003. INDEX FUND VENDORS Index funds are available from several firms including Vanguard, Fidelity, Barclays Global Investors and Dimensional Fund Advisors (DFA.). Vanguard is one of the early founders of index funds. Fidelity is a large mutual fund complex, and there are several index fund offerings from them. Barclays' index offerings are mostly Exchange Traded Funds. DFA funds are available from independent financial advisors. DFA's offerings have more "small value" style emphasis, due to Fama and French's study on stock returns. SYNTHETIC INDEXING Synthetic Indexing refers to a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to replicate the performance of a similar overall investment in the equities making up the index. Although maintaining the future position has a slightly higher cost structure than traditional passive sampling, synthetic indexing can result in more favourable tax treatment, particularly for international investors who are subject to dividend withholding taxes. The bond portion can also hold higher yielding instruments, with a trade-off of corresponding higher risk, a technique referred to as enhanced indexing. {Link without Title} ENHANCED INDEXING Enhanced Indexing refers to an approach to index fund management that uses a variety of techniques to create index funds that seek to emphasize performance, possibly using Active Management s. Enhanced index funds employ a variety of enhancement techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies. Cost advantage of indexing could be reduced by employing active management. ORIGINS OF THE INDEX FUND The history that lead to the creation of index funds can be traced back to 1654, see this extensive history of modern portfolio theory. In 1973, Burton Malkiel published his book ''"A Random Walk Down Wall Street"'' which presented academic findings for the lay public. It was becoming well-known in the lay financial press that most mutual funds were not beating the market indices, to which the standard reply was made "of course, you can't buy an index." Malkiel said, "It's time the public can." . When Bogle started the First Index Investment Trust on December 31 , 1975 , it was labeled Bogle's Follies and regarded as un-American, because it sought to achieve the averages rather than insisting that Americans had to play to win. This first Index Mutual Fund offered to individual investors was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999, an astonishing growth rate of fifty percent per year. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000. "But in the financial markets it is always wise to expect the unexpected" John McQuown at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1981, Rex Sinquefield became chairman of Dimensional Fund Advisors (DFA), and McQuown joined its Board of Directors. DFA further developed indexed based investment strategies and currently has $86 billion under management (as of Dec. 2005). Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclay's Global Investors. It is one of the world's largest money managers with over $1.5 trillion under management As Of 2005 . REFERENCES |
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