Index Fund Investing

As a result of Sharpe’s research, investors are searching for ways to diversify and invest in a variety of securities.

The Dow Jones Industrial Average tracks 30 stocks chosen by the editors of the Wall Street Journal and has the longest history of any index. The S&P 500 Index includes 500 stocks and, as a result, more broadly represents the market than the Dow. However, it still does not represent the entirety of stocks worldwide. There are hundreds of indexes, each representing a different portion of the worldwide stock and bond markets.

An index fund is a mutual fund that attempts to parallel the financial performance of a certain index by holding the same securities in the same proportions. The costs of managing the fund are minimal because it buys what is in the index, although every fund will have fees for administration, reporting, and maintenance.

An index is an arbitrary selection of securities and is not an asset class, even if the index includes hundreds or thousands of securities.

Index funds have been a bonus for retail investors, and investors are better off using indexes rather than active managers. However, an index, even one that includes hundreds or thousands of securities, is only an arbitrary selection of securities and is not an asset class. Indexes were made to represent the overall performance of the market, and were never intended to be investment vehicles. They do not provide a diversified asset allocation.

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RECONSTITUTION COST: A MAJOR DISADVANTAGE OF INDEX INVESTING

Reconstitution is the annual change in the index’s composition. Between reconstitution dates, the holdings in an index remain the same. For example, if a small company becomes mid-cap or is acquired by a large company, it will be held until the next reconstitution. As a result, indexes can experience significant “style drift,” which can cause them to only partially obtain asset class returns because some securities in the index have undergone changes.

Prior to the reconstitution, the index sponsor usually announces which securities are to be added or deleted. Since an index is only a reporting mechanism, a manager must buy and own specific securities to replicate the index’s performance. Prices can distort due to the spike in demand when many index managers buy or sell securities on the same day: by some estimates, a stock may rise in price by up to more than 7%7 when it is added to the S&P 500 index. However, the index manager must buy the new security on the precise day that it is added to the index regardless of rising prices.

T. Clifton Green and Russel Jame, “Understanding the S&P 500 CompositionEffect: Evidence from Transaction Data,” March 2010.