Index Investing

What Is Index Investing?

Index investing is a passive investment technique that attempts to generate returns similar to a broad market index. Investors use this buy-and-hold strategy to replicate the performance of a specific index — generally an equity or fixed-income index — by purchasing the component securities of the index, or investing in an index mutual fund or exchange traded fund (ETF) that itself closely tracks the underlying index.

There are several advantages of index investing. For one, empirical research finds index investing tends to outperform active management over a long time frame. Taking a hands-off approach to investing eliminates many of the biases and uncertainties that arise in a stock-picking strategy.

Index investing, as well as other passive strategies, may be contrasted with active investment.

How Index Investing Works

Index investing is an effective strategy to manage risk and gain consistent returns. Proponents of the strategy eschew active investing because modern financial theory claims it's impossible to "beat the market" once trading costs and taxes are taken into account.

Since index investing takes a passive approach, index funds usually have lower management fees and expense ratios (ERs) than actively managed funds. The simplicity of tracking the market without a portfolio manager allows providers to maintain modest fees. Index funds also tend to be more tax-efficient than active funds because they make less frequent trades.

More importantly, index investing is an effective method of diversifying against risks. An index fund consists of a broad basket of assets instead of a few investments. This serves to minimize unsystematic risk related to a specific company or industry without decreasing expected returns.

For many index investors, the S&P 500 is the most common benchmark to evaluate performance against, as it gauges the health of the U.S. economy. Other widely followed index funds track the performance of the Dow Jones Industrial Average (DJIA) and the corporate bond sector.

Active U.S. equity funds have experienced outflows every year since 2006, according to Morningstar, with most of that withdrawn money being plowed into passive funds.

Index Investing Methods

Purchasing every stock in an index at its given component weight is the most complete way to ensure that a portfolio will achieve the same risk and return profile as the benchmark itself. However, depending on the index, this can be time-consuming and quite costly to implement.

For instance, to replicate the S&P 500 index, an investor would need to accumulate positions in each of the 500 companies that are inside the index. For the Russell 2000, there would need to be 2000 different positions. Depending on commissions paid to a broker, this can become cost-prohibitive.

More cost-effective ways to track an index involve only owning the most heavily-weighted index components or sampling a certain proportion, say 20%, of the index's holdings. The most cost-effective way to own an index these days is to seek out an index mutual fund or ETF that does all of that work for you, combining the entire index essentially into a single security or share.

Limitations of Index Investing

Despite gaining immense popularity in recent years, there are some limitations to index investing. Many index funds are formed on a market capitalization basis, meaning the top holdings have an outsized weight on broad market movements. So, if Amazon.com Inc. (AMZN) and Facebook Inc. (FB), for instance, experience a weak quarter it would have a noticeable impact on the entire index.

This entirely passive strategy neglects a subset of the investment universe focused on market factors such as value, momentum, and quality. These factors now constitute a corner of investing called smart-beta, which attempts to deliver better risk-adjusted returns than a market-cap-weighted index. Smart-beta funds offer the same benefits of a passive strategy, with the additional upside of active management, otherwise known as alpha.

Real World Example of Index Investing

Index mutual funds have been around since the 1970s. The one fund that started it all, founded by Vanguard Chair John Bogle in 1976, remains one of the best for its overall long-term performance and low cost.

Over the years, the Vanguard 500 Index Fund has tracked the S&P 500 faithfully, in composition and performance. For its Admiral Shares, the ER is 0.04%, and its minimum investment is $3,000.