Should I use index funds as my investment strategy?
In today’s environment, index funds are often mentioned as a prudent way to invest. Are they? To provide a little background, the three most popular styles of investment management are conventional, index, and the evidence-based approach.
The first, and the most widely discussed in the media until recently, is conventional (or active) management. The idea here is to buy low and sell high based on a variety of factors (dependent on the specific investor). This style of investing relies on forecasts of undervalued securities and is fairly typical of the large wire-house investment firms. For example, an analyst in a New York headquarters changes the rating of a stock to “outperform” or “buy”. This is passed down to advisors in the field across the country and these financial advisors pass on the recommendations to their clients and many may buy the stock for their investment portfolio. This type of investment management can generate higher expenses, higher trading costs, and higher risks. Typically this involves market timing (buy and selling the investment vehicle based on specific factors present in the market as determined by the investor or advisor). Market timing has been demonstrated to not work very well over the long term. As mentioned in an earlier post, an oft-cited study by University of Michigan Professor H. Nejat Seyhun, highlights the issue with great clarity. One key take away from this study states that from 1963 to 1993, only 1.2% of the days the market was open for business accounted for 95% of the market gains.
Index (or passive) management, which has been generally covered positively in the press over the last decade, dictates that a fund follow a market index. An index fund attempts to match an index (e.g., the S&P 500 index) performance by restricting the fund to only hold the actual securities in the index. Broad-based indexes may offer better diversification**, have lower fees, and follow a more transparent investment process than conventional management. This strategy focuses on low tracking error, meaning that the fund tracks the index as closely as possible. One challenge with index funds is that when the index changes, for instance when a stock is added or subtracted, the index fund manager must go out to the market and buy or sell the particular stock. When this happens, since the index is public, the fund manager must compete with others who are looking to follow the index, and the price of the stock will be affected (basic supply and demand). This can affect the performance of the index fund.
A third style, evidence-based investing, gains insight about the markets and investment returns from academic, scientific research. Funds following this style of investing do not track an index explicitly– their funds trade on their own timetable rather than strictly following an index (i.e., buying and selling securities that are added or removed from a tracked index). This approach helps enable these funds avoid overpaying or underselling securities. In addition, academic research shows that some market areas have higher expected returns than others.* This style emphasizes securities with higher expected returns by over-weighting them compared to their market capitalization weight in a commercial index.
We hope this primer is helpful as you consider your investment philosophy. As always, we are here to answer any questions you may have of us. You may read more about our thoughts in the investment Philosophy page, or download our top 10 guide ” Pursuing a Better Investment Experience” from our homepage in the upper top right corner.
S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market. Investors cannot invest directly in an index.
* Eugene F. Fama and Kenneth R. French, “The Cross Section of Expected Stock Returns”, Journal of Finance, Volume XLVII, No 2, June 1992.
**Diversification does not guarantee a profit or protect against a loss.