Hurting Traders’ feelings in 5… 4…. 3… 2…
Index funds are mutual funds that track the performance of specific index, like the 50 stocks in Nifty. They’re not sexy, and they’re unlikely to help you get rich quickly, but today they account for more than 20% of all mutual fund assets in US. An exchange-traded fund, or ETF, is an investment that is constructed like a mutual fund but trades like an individual stock. The theoretical underpinning of the value provided by index funds is intense competition.
Making the Market versus Beating the Market
Because investors will act on important information when they come across it, market prices usually reflect all relevant information. Such a market is said to be efficient. An entire theory attaches to this thought process, called the efficient market hypothesis. Its roots go back to 1900 and the doctoral dissertation of French mathematician Louis Bachelier, who argued that prices typically follow a random pattern.
The concept of efficient markets is upsetting to many active fund managers. It basically says that a monkey throwing darts at the stock pages of The Wall Street Journal will select a portfolio that performs about as well as one chosen by professional fund managers. The reason is that investors compete intensely; over time, competition swallows all the easy money opportunities. Only new information impacts the price of a stock, and that is, by definition, unpredictable.
Noble laureate Eugene Fama breaks the efficient market hypothesis into 3 forms, or information :
Weak-form efficiency, wherein investors can’t consistently beat the market using historical price and volume data.
Semi-strong form efficiency, wherein investors can’t consistently beat the market using any public information; not only the historical price and volume information, But also a company’s financial statements, and whatever other information is available.
Strong-form efficiency, wherein investors can’t consistently beat the market using any information, whether historical price and volume data; public information; or private, inside information.
The bulk of the academic studies of the efficient-market hypothesis find that the market is both weak form and semi-strong form efficient, but that the market is not strong-form efficient.
Rather than citing a laundry list of academic studies, perhaps the best “proof,” of weak and semi-strong market efficiency is the performance of professional fund managers. Most can’t beat a simple index, despite their advantages.
An index tracks a basket of stocks. The oldest is the Dow Jones Industrial Average, which tracks the performance of 30 blue chip stocks. Index funds have very low trading costs, since they essentially buy and hold forever. The typical cost of an index fund is about 0.2%, and sometimes much less. Some index funds charge no fee, with the sponsoring company hoping to make money by also selling the customer some other product or service.
An index fund helps answer at least two important questions. The first is, “How did the market do today?” You need to measure market performance to answer that question.
The second is, “How is my portfolio doing?” To answer that question, you probably want to compare the performance of your portfolio to a benchmark like a market index such as the
A quantitative group within Wells Fargo created the first index fund in 1971. It was an equal-weighted index based on a group of large stocks trading on the New York Stock Exchange. Equal weighted means the price changes in the smallest stock have the same impact on the index returns as the price changes in the
John Bogle, the founder and retired CEO of the Vanguard Group created the first index mutual fund in 1975. This landmark fund, based on the performance of the S&P 500, changed the financial landscape in ways that Bogle probably never imagined.
John Bogle was born May 8, 1929, in Montclair, NJ. His family, like many others at the time, lost most of their wealth during the Great Depression. Nevertheless, he attended the Blair Academy on a scholarship. He also worked at a series of jobs to help pay for school expenses. Bogle attended Princeton University, also on scholarship, where he studied economics. One afternoon, in the Princeton library, Bogle came across a Fortune magazine article titled “Big Money in Boston.”
Mutual funds, as we know them today, had originated in Boston in 1924, and most of the funds at the time operated in that region.Bogle decided to write his senior thesis on mutual funds. His thesis found that the average mutual fund didn’t outperform the market, and he suggested that the industry would be best served by lowering sales charges and management fees.
Princeton alumnus Walter L. Morgan, the founder of the Wellington Fund, read Bogle’s thesis and offered him a job. By the mid-1960s, he made it clear that Bogle was in line to run the firm. Bogle officially became president of Wellington in 1967 and CEO in 1971. Wellington was an actively managed investment firm it did not follow the passive management strategy of index investing that Bogle prescribed and it remains so to this day.
The late 1960s were a bull market in U.S. stocks, and the funds that did the best-employed momentum and high turnover strategies. They owned names like Xerox, Polaroid, and IBM and other well-known growth stocks. The investment mindset at the time was that these companies were so strong that they could be successfully bought regardless of their price.
The thinking, which was eventually shown to be flawed, is that these companies could grow their way out of any problems.
Wellington’s performance in the mid-1960s was disappointing and, in 1966, Bogle made the decision to merge with Thorndike,Doran, Paine and Lewis. The go-go stocks began to fall a short time later and ran into a terrible bear market during the 1973– 1974 period, when the S&P 500 fell by about half.
Vanguard was not organized as a traditional for-profit corporation, but rather as a mutual share company. Vanguard returns all its profits to the mutual funds it administers. This practice results in lowering expense ratios even beyond the relatively low costs of index fund-based investing. In a mutual form of ownership, the shareholders are the owners.
Vanguard quickly expanded into running its own funds: first active, then passive (or index) funds and still offers many actively managed funds that account for about one-quarter to one-third of the firm’s assets. But even these are relatively low cost, and the net profits from the management fees of running the funds accrue to the shareholders of the funds. With about $3 trillion in client assets, Vanguard is a major presence in the mutual fund industry today.
At the end of 1975, when Vanguard launched the first index mutual fund, some critics said that trying to market average returns was un-American. Bogle was hoping to raise $150 million at the launch, but raised only $11.3 million, and it would be another decade before the fund had any material competition in index based investing. But over time, people couldn’t argue with the fund’s performance, tax efficiency, and bargain-basement fees.
Advice for Investors
John Bogle stepped down as CEO of Vanguard in 1995 and left its board in 1999. He has written about 10 books, in which he lays out his investment philosophy. Bogle cautions against paying a lot of money for financial advice. Although not denying thatsome investors could benefit from using advisors, for example, to prevent them from doing irrational things with their money, he questions how much value advisors can add to performance.
Bogle believes that past fund performance may offer some predictive value in establishing the risk of a fund, and its long-term consistency, but it should not be overrated or overemphasized.For example, a fund that owns mostly utility and consumer staples stocks is likely to have less risk than the market as a whole over
long periods, assuming the fund doesn’t materially change its strategy or types of holdings.
Bogle also suggests that we be somewhat wary of star mutual fund managers. For every Peter Lynch or John Neff who consistently generate strong returns, many one- and two-hit wonders call a dramatic market turn and later badly underperform.
Bogle cautions awareness of the law of large numbers for actively managed funds. That is, the bigger a fund gets, the harder is it to outperform. One reason is that large funds are generally tilted towards large stocks that are widely followed; the manager is unlikely to uncover something unknown by the market, generally a precondition for outperformance.
For nearly all investors, Bogle suggests a long-term buy and hold approach. He advises looking at your portfolio once a year so you can have the miracle of compound interest and returns work in your favor without the urge to make too many changes.
What are your thoughts on Index funds, please do share your thoughts, this topic usually gets a very bipolar partisan response.