View source for Index fund

{{Short description|Type of mutual fund or exchange-traded fund}}
{{Finance sidebar}}
{{Financial markets}}

An '''index fund''' (also '''index tracker''') is a [[mutual fund]] or [[exchange-traded fund]] (ETF) designed to follow certain preset rules so that it can replicate the performance of a specified basket ([[Benchmark (finance)|"benchmark"]]) of underlying securities.<ref name="ssrn.com">{{Cite web |title=Reasonable Investor(s) | ssrn=2579510 |url=https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2579510 |access-date=2024-02-08}}</ref> 

The main advantage of index funds for investors is they do not require much time to manage{{Em dash}}the investors will not need to spend time [[Stock valuation|analyzing]] various [[stock]]s or [[Investment management|stock portfolios]]. Most investors also find it difficult to beat the [[Investment performance|performance]] of the [[S&P 500]] index.<ref>{{Cite web|title=Can Anybody Beat the Market?|url=https://www.investopedia.com/ask/answers/12/beating-the-market.asp|access-date=2022-01-03|website=Investopedia}}</ref>  
Indeed, passively managed funds, such as index funds, consistently outperform actively managed funds.<ref>{{Cite news |date=2022-12-02 |title=Mutual Funds That Consistently Beat the Market? Not One of 2,132. |work=The New York Times |url=https://www.nytimes.com/2022/12/02/business/stock-market-index-funds.html |access-date=2023-08-21}}</ref><ref name=":12">{{Cite journal |last=Choi |first=James J. |date=2022 |title=Popular Personal Financial Advice versus the Professors |journal=Journal of Economic Perspectives |volume=36 |issue=4 |pages=167–192 |doi=10.1257/jep.36.4.167 |issn=0895-3309 |doi-access=free}}</ref><ref>{{Cite journal |last=Malkiel |first=Burton G. |date=2013 |title=Asset Management Fees and the Growth of Finance |journal=Journal of Economic Perspectives |volume=27 |issue=2 |pages=97–108 |doi=10.1257/jep.27.2.97 |issn=0895-3309|doi-access=free }}</ref>
Thus investors, academicians, and authors such as [[Warren Buffett]], [[John C. Bogle]], [[John J. Brennan (businessman)|Jack Brennan]], [[Paul Samuelson]], [[Burton Malkiel]], [[David Swensen]], [[Benjamin Graham]], [[Gene Fama]], [[William J. Bernstein]], and [[Andrew Tobias]] have long been strong proponents of index funds.<ref name="Investors_info">
* {{Cite web |last=Pisani |first=Bob |date=2022-10-03 |title=Billionaire Warren Buffett swears by this inexpensive investing strategy that anyone can try |url=https://www.cnbc.com/2022/10/03/billionaire-warren-buffett-swears-by-this-inexpensive-investing-strategy-that-anyone-can-try.html |access-date=2024-02-08 |website=CNBC}}
* {{Cite news |last=Krishnan |first=Aarati |date=2022-08-07 |title=Why Buffett bats for index funds |url=https://www.thehindu.com/business/markets/why-buffett-bats-forindex-funds/article65738479.ece |access-date=2024-02-08 |work=The Hindu |issn=0971-751X}}
* {{Cite news |last=Martin |first=Emmie |date=2018-01-03 |title=Warren Buffett just won a $1 million bet—and highlighted one of the best ways to grow wealth |url=https://www.cnbc.com/2018/01/03/why-warren-buffett-says-index-funds-are-the-best-investment.html |access-date=2024-02-08 |work=[[CNBC]]}}
* {{Cite web |title=Warren Buffett on Index Funds |url=https://www.nasdaq.com/articles/warren-buffett-index-funds-2017-06-25 |access-date=2024-02-08}}
* {{Cite news |first=Stan |last=Choe |date=2019-01-23 |title=40 years after his "folly," Bogle's index funds reign |url=https://apnews.com/article/171a636f31b24167ae3c81cb77bcf695 |access-date=2024-02-08 |work=[[AP News]]}}
* {{Cite web |title=John Bogle's Advice: Live Long and Prosper, on Index Funds |url=https://knowledge.wharton.upenn.edu/article/john-c-bogles-advice-live-long-and-prosper-on-index-funds/ |access-date=2024-02-08 |website=Knowledge at Wharton}}
* {{Cite book |surname=Siegel |given=Jeremy J. |year=2019 |chapter=Climbing Mount Everest: Paul Samuelson on Financial Theory and Practice |editor-given1=Robert A. |editor-surname1=Cord |editor-given2=Richard G. |editor-surname2=Anderson |editor-given3=William A. |editor-surname3=Barnett |title=Remaking Economics: Eminent Post-War Economists |publisher=Palgrave Macmillan London |isbn=978-1-137-56812-0 |doi=10.1057/978-1-137-56812-0_13}} 
* {{Cite web |title=Financial Wisdom from Jack Brennan, Former CEO of Vanguard |url=https://www.boldin.com/retirement/financial-wisdom-from-jack-brennan-former-ceo-of-vanguard/ |access-date=July 15, 2021}}
* {{Cite web |title=Interview with Eugene Fama |url=https://www.minneapolisfed.org/article/2007/interview-with-eugene-fama |access-date=December 1, 2007}}
* {{Cite web |title=Are index funds still the way to go? |url=https://yalealumnimagazine.org/articles/5729-are-index-funds-still-the-way-to-go |access-date=October 15, 2023}}
* {{Cite web |title=Burton Malkiel Advocates for Direct Indexing |url=https://www.nasdaq.com/articles/burton-malkiel-advocates-for-direct-indexing |access-date=February 21, 2024}}
* {{Cite news |via=[[Yahoo Finance]] |date=March 13, 2024 |first=Rebecca |last=Mezistrano |title=Unless you're Warren Buffett, you're better off investing in an ETF, top economist says |url=https://finance.yahoo.com/news/unless-youre-warren-buffett-youre-010000011.html |access-date=March 13, 2024 |work=[[TheStreet]]}}
* {{Cite web |title=Paul Samuelson and the Birth of the Index Fund |url=https://community.macmillanlearning.com/t5/economics-blog/paul-samuelson-and-the-birth-of-the-index-fund/ba-p/3279 |access-date=September 3, 2011}}
* {{Cite web |title=Burton Malkiel Advocates for Direct Indexing |url=https://www.nasdaq.com/articles/burton-malkiel-advocates-for-direct-indexing |access-date=February 21, 2024}}
* {{Cite web |title=How To Build a Complete Benjamin Graham Portfolio |url=https://www.grahamvalue.com/article/how-build-complete-benjamin-graham-portfolio |access-date=April 10, 2020}}
* {{Cite web |title=Benjamin Graham: Passive Advocate? |url=https://www.etf.com/sections/features/benjamin-graham-passive-advocate |access-date=Jul 20, 2023}}</ref>

==Construction==
The above mentioned rules may include tracking prominent [[Index (economics)|indices]] like the S&P 500 or the [[Dow Jones Industrial Average]] or implementation rules, such as tax-management, [[tracking error]] minimization, large block trading or patient/flexible trading strategies that allow for greater tracking error but lower market impact costs. Index funds may also have rules that screen for social and sustainable criteria.

In general, tracking can be achieved by trying to hold all of the [[Security (finance)|securities]] in the index in the same proportions as the index. Other methods include statistically sampling the market and holding "representative" securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and are thus subject to a form of [[passive management]].
See {{slink|#Indexing methods}} below.

An index fund's rules of construction clearly identify the type of companies suitable for the fund. The most commonly known index fund in the United States, the [[S%26P_500#Mutual_and_exchange-traded_funds|S&P 500 Index Fund]], is based on the rules established by [[S&P Dow Jones Indices]] for their [[S&P 500 Index]]. 

Equity index funds would include groups of stocks with similar characteristics such as the size, value, profitability and/or geographic location of the companies. A group of stocks may include companies from the United States, non-US developed, [[emerging markets]] or [[frontier market]] countries. 

Additional index funds within these geographic markets may include indexes of companies that include rules based on company characteristics or factors, such as companies that are small, mid-sized, large, small value, large value, small growth, large growth, the level of gross profitability or investment capital, real estate, or indexes based on commodities and fixed-income. 

Companies are purchased and held within the index fund when they meet the specific index rules or parameters and are sold when they move outside of those rules or parameters. 
While index providers often emphasize that they are for-profit organizations, index providers have the ability to act as "reluctant regulators" when determining which companies are suitable for an index.<ref>{{Cite journal|last1=Hirst|first1=Scott|last2=Kastiel|first2=Kobi|date=2019-05-01|title=Corporate Governance by Index Exclusion|url=https://scholarship.law.bu.edu/faculty_scholarship/601|journal=Boston University Law Review|volume=99|issue=3|pages=1229|ssrn=3398578}}</ref>'''{{rp|1244–45}}'''<!-- Think of an index fund as an investment utilizing rules-based investing. --> 
Some index providers announce changes of the companies in their index before the change date whilst other index providers do not make such announcements.

==Market size==
{{update section|date=March 2025}}
{{As of|2014}}, index funds made up 20.2% of equity mutual fund assets in the US. Index domestic equity mutual funds and index-based exchange-traded funds (ETFs), have benefited from a trend towards more index-oriented investment products. From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in new net cash, including reinvested dividends. Index-based domestic equity ETFs have grown particularly quickly, attracting almost twice the flows of index domestic equity mutual funds since 2007. In contrast, actively managed domestic equity mutual funds experienced a net outflow of $659 billion, including reinvested dividends, from 2007 to 2014.<ref>{{Cite web |url=http://www.icifactbook.org/fb_ch2.html#popularity |title=2014 Investment Company Fact Book |access-date=2014-11-05 |archive-url=https://web.archive.org/web/20160620173810/http://www.icifactbook.org/fb_ch2.html#popularity |archive-date=2016-06-20 |url-status=dead }}</ref>

==Origins==
The first theoretical model for an index fund was suggested in 1960 by [[Edward J Renshaw|Edward Renshaw]] and [[Paul J Feldstein|Paul Feldstein]], both students at the [[University of Chicago]]. While their idea for an "Unmanaged Investment Company" garnered little support, it did start off a sequence of events in the 1960s.<ref name="TMOTRM">{{cite book|last=Fox|first=Justin|title=The Myth of the Rational Market|pages=111–112|chapter=Chapter 7: Jack Bogle takes on the performance cult (and wins)|publisher=HarperCollins|location=USA|date=2011|isbn=978-0-06-059903-4}}</ref>

Qualidex Fund, Inc., a Florida Corporation, chartered on May 23, 1967 (317247) by Richard A. Beach (BSBA Banking and Finance, University of Florida, 1957) and joined by Walton D. Dutcher Jr., filed a registration statement (2-38624) with the [[U.S. Securities and Exchange Commission|SEC]] on October 20, 1970 which became effective on July 31, 1972. "The fund organized as an open-end, diversified investment company whose investment objective is to approximate the performance of the Dow Jones Industrial Stock Average", thereby becoming the first index fund.{{citation needed|date=August 2023}}

In 1973, [[Burton Malkiel]] wrote ''[[A Random Walk Down Wall Street]]'', which presented academic findings for the lay public. It was becoming well known in the popular financial press that most mutual funds were not beating the market indices. Malkiel wrote:

{{blockquote|What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out "You can't buy the averages." It's time the public could.

...there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis.... Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.<ref>{{cite book |author=Burton Malkiel |year=1973 |title=A Random Walk Down Wall Street |publisher=W. W. Norton |pages=226–7 |isbn=0-393-05500-0}}</ref>}}

[[John Bogle]] graduated from [[Princeton University]] in 1951, where his senior thesis was titled ''The Economic Role of the Investment Company''.<ref>{{Cite web |last1=Bogle |first1=John |date=1950–1951 |url=http://findingaids.princeton.edu/collections/MC206/c0087|title= Senior Thesis, ''The Economic Role of the Investment Company''|publisher=Princeton University Library}}</ref> Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: [[Paul Samuelson]]'s 1974 paper, "Challenge to Judgment"; [[Charles D. Ellis|Charles Ellis]]' 1975 study, "The Loser's Game"; and Al Ehrbar's 1975 [[Fortune (magazine)|''Fortune'' magazine]] article on indexing. Bogle founded [[The Vanguard Group]] in 1974; as of 2009 it was the largest mutual fund company in the United States.{{citation needed|date=April 2018}}

Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly".<ref>{{cite web |first=John |last=Bogle |date=2006 |title=The First Index Mutual Fund: A History of Vanguard Index Trust and the Vanguard Index Strategy |url=http://www.vanguard.com/bogle_site/lib/sp19970401.html |website=Bogle Financial Center |publisher=[[The Vanguard Group]] |access-date=2007-08-04 |archive-url=https://web.archive.org/web/20130507033534/http://www.vanguard.com/bogle_site/lib/sp19970401.html |archive-date=2013-05-07 |url-status=dead }}</ref> In the first five years of Bogle's company, it made 17 million dollars.<ref>{{Cite news|url=https://www.economist.com/|title=The Economist - World News, Politics, Economics, Business & Finance|newspaper=The Economist|access-date=2019-02-04}}</ref> [[Fidelity Investments]] Chairman [[Edward Johnson III|Edward Johnson]] was quoted as saying that he "[couldn't] believe that the great mass of investors are going to be satisfied with receiving just average returns".<ref>{{cite news |first=Richard |last=Ferri |title=All About Index Funds |url=https://books.google.com/books?id=wuTWFNXuNw8C&q=index+fund+unamerican&pg=PA38 |publisher=[[McGraw-Hill]] |date=2006-12-22|isbn=9780071423380 }}</ref> Bogle's fund was later renamed the Vanguard 500 Index Fund, which tracks the [[S&P 500|Standard and Poor's 500 Index]]. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999; this astonishing increase was funded by the market's increasing willingness to invest in such a product. Bogle predicted in January 1992 that it would very likely surpass the [[Magellan Fund]] before 2001, which it did in 2000.{{citation needed|date=April 2018}}

John McQuown and [[David G. Booth]] of [[Wells Fargo]], and [[Rex Sinquefield]] of the [[American National Bank]] in Chicago, established the first two 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 1971, [[Jeremy Grantham]] and Dean LeBaron at Batterymarch Financial Management "described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. Two years later, in December 1974, the firm finally attracted its first index client."<ref>{{cite book |first=John |last=Bogle |title=Common Sense on Mutual Funds|year=1999 |url=https://archive.org/details/commonsenseonmut00bogl |url-access=registration }}</ref>

In 1981, Booth and Sinquefield started [[Dimensional Fund Advisors]] (DFA), and McQuown joined its board of directors. DFA further developed indexed-based investment strategies. Vanguard started its first bond index fund in 1986.

[[Frederick L. A. Grauer]] at Wells Fargo harnessed McQuown and Booth's indexing theories, which led to Wells Fargo's pension funds managing over $69 billion in 1989<ref>{{cite journal|title=How This Man Manages $69 Billion|journal=Fortune|year=1989}}</ref> and over $565 billion in 1998. In 1996, Wells Fargo sold its indexing operation to [[Barclays|Barclays Bank of London]], which it operated under the name Barclays Global Investors (BGI). [[BlackRock|Blackrock, Inc.]] acquired BGI in 2009; the acquisition included BGI's index fund management (both its institutional funds and its iShares ETF business) and its active management.

==Economic theory==
Economist [[Eugene Fama]] said, "I take the [[efficient market hypothesis|market efficiency hypothesis]] to be the simple statement that security prices fully reflect all available information." 
A precondition for this "strong version" of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0.<ref>Grossman and Stiglitz (1980)</ref>{{Full citation needed|date=December 2023}}
A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed [[marginal costs]].<ref>Jensen (1978)</ref>{{Full citation needed|date=December 2023}}

Economists cite the [[efficient-market hypothesis]] (EMH) as the fundamental premise that justifies the creation of the index funds. The hypothesis implies that [[Investment management|fund managers]] and stock analysts are constantly looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fortune of a company will rapidly be incorporated into stock prices. It is postulated therefore that it is very difficult to tell ahead of time which stocks will out-perform the market.<ref name="burton">Burton G. Malkiel, ''A Random Walk Down Wall Street'', W. W. Norton, 1996, {{ISBN|0-393-03888-2}}</ref> By creating an index fund that mirrors the whole market the inefficiencies of stock selection are avoided.

In particular, the EMH says that economic profits cannot be wrung from [[stock picking]]. This is not to say that a stock picker cannot achieve a superior return, just that the excess return will on average not exceed the costs of winning it (including salaries, information costs, and trading costs). The conclusion is that most investors would be better off buying a cheap index fund. Note that return refers to the [[ex-ante]] expectation; [[Ex post#ex post|ex-post]] realisation of payoffs may make some stock-pickers appear successful. In addition, there have been many [[Efficient-market hypothesis#Criticism|criticism]] of the EMH.

Some legal scholars have previously suggested a value maximization and [[agency theory|agency-costs theory]] for understanding index funds stewardship.<ref>{{Cite journal|last=Hirst|first=Scott|date=2019-09-01|title=Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy|url=https://scholarship.law.bu.edu/faculty_scholarship/477|journal=ECGI - Law Working Paper|volume=433/2018}}</ref>'''{{rp|4}}'''

==Fees==
The lack of [[active management]] generally gives the advantage of much lower fees compared to actively managed mutual funds and, in taxable accounts, lower taxes. In addition it is usually impossible to precisely mirror the index as the models for sampling and mirroring, by their nature, cannot be 100% accurate. The difference between the index performance and the fund performance is called the "[[tracking error]]", or, colloquially, "jitter".

Index funds are available from many [[Investment management|investment managers]]. Some common indices include the [[S&P 500]], the [[Nikkei 225]], and the [[FTSE 100]]. Less common indexes come from academics like [[Eugene Fama]] and [[Kenneth French]], who created "research indexes" in order to develop asset pricing models, such as their Three Factor Model. The [[Fama–French three-factor model]] is used by [[Dimensional Fund Advisors]] to design their index funds. [[Robert D. Arnott|Robert Arnott]] and Professor [[Jeremy Siegel]] have also created new competing [[fundamentally based indexes]] based on such criteria as [[dividend]]s, [[earnings]], [[book value]], and [[sales]].

==Indexing methods==

===Traditional indexing===
Indexing is traditionally known as the practice of owning a representative collection of [[Security (finance)|securities]], in the same ratios as the target index. Modification of security holdings happens only periodically, when companies enter or leave the target index.<ref name=":0">{{Cite web |date=31 December 2023 |title=What you need to know about physical and synthetic ETFs |url=http://www.vanguard.co.uk/professional/vanguard-365/investment-knowledge/etf-knowledge/etf-basics |access-date=2025-06-09 |publisher=The Vanguard Group |language=en}}</ref>

===Synthetic indexing===
Synthetic indexing is 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 favorable tax treatment, particularly for international investors who are subject to U.S. dividend [[withholding tax]]es.<ref name=":0" /> The bond portion can hold higher yielding instruments, with a trade-off of corresponding higher risk.

===Enhanced indexing===
[[Enhanced indexing]] is a catch-all term referring to improvements to index fund management that emphasize performance, possibly using [[active management]]. 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. The cost advantage of indexing could be reduced or eliminated by employing active management. Enhanced indexing strategies help in offsetting the proportion of tracking error that would come from expenses and transaction costs. These enhancement strategies can be:
* Lower cost, issue selection, [[yield curve]] positioning.
* Sector and quality positioning and call exposure positioning.

==Advantages==

===Low costs===
Because the composition of a target index is a known quantity, relative to actively managed funds, it costs less to run an index fund.<ref name="ssrn.com"/> Typically expense ratios of an index fund range from 0.10% for U.S. Large Company Indexes to 0.70% for Emerging Market Indexes. The expense ratio of the average large cap actively managed mutual fund as of 2015 is 1.15%.{{Cn|date=February 2025}} If a mutual fund produces 10% return before expenses, taking account of the expense ratio difference would result in an after expense return of 9.9% for the large cap index fund versus 8.85% for the actively managed large cap fund.  Similarly, if a mutual fund produces only a 1% return before expenses, taking account of the expense ratio difference would result in an after expense return of 0.9% for the large cap index fund versus a 0.15% loss for the actively managed large cap fund.

===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 {{clarify span|rebalancing|date=December 2020}} every six months or every year.

===Lower turnovers===
Turnover refers to the selling and buying of securities by the fund manager. Selling securities in some jurisdictions may result in [[capital gains tax]] charges, which are sometimes passed on to fund investors. Even in the absence of taxes, turnover has both explicit and implicit costs, which directly reduce returns on a dollar-for-dollar basis. Because index funds are passive investments, the turnovers tend to be lower than actively managed funds.

===No style drift===
[[Style drift]] occurs when actively managed mutual funds go outside of their described style (i.e., mid-cap value, large cap income, etc.) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund, this drift is not possible and accurate diversification of a portfolio is increased.

==Disadvantages==

===Losses to arbitrageurs===
Index funds must periodically "rebalance" or adjust their portfolios to match the new prices and [[market capitalization]] of the underlying securities in the [[stock index|stock or other index]]es that they track.<ref name=BloombergFA>{{cite news|title=High-Frequency Firms Tripled Trades in Stock Rout, Wedbush Says|url=http://www.fa-mag.com/news/high-frequency-firms-tripled-trades-in-stock-rout-wedbush-says-8030.html|access-date=26 March 2013|newspaper=Bloomberg/Financial Advisor|date=August 12, 2011}}</ref><ref>{{cite news|last=Siedle|first=Ted|title=Americans Want More Social Security, Not Less|url=https://www.forbes.com/sites/edwardsiedle/2013/03/25/americans-want-more-social-security-not-less-let-them-buy-it/|access-date=26 March 2013|newspaper=Forbes|date=March 25, 2013}}</ref> This allows [[algorithmic trading|algorithmic traders]] (80% of the trades of whom involve the top 20% most popular securities<ref name=BloombergFA/>) to perform [[index arbitrage]] by anticipating and trading ahead of [[Market impact|stock price movements]] caused by mutual fund rebalancing, making a profit on foreknowledge of the large institutional block orders.<ref name=AmeryRebalancing>{{cite news|last=Amery|first=Paul|title=Know Your Enemy|url=http://www.indexuniverse.eu/europe/opinion-and-analysis/7634-know-your-enemy.html?showall=&fullart=1&start=2|access-date=26 March 2013|newspaper=IndexUniverse.eu|date=November 11, 2010}}</ref><ref>{{cite news|last=Salmon|first=Felix|title=What's driving the Total Return ETF?|url=http://blogs.reuters.com/felix-salmon/2012/07/18/whats-driving-the-total-return-etf/|archive-url=https://web.archive.org/web/20120720041358/http://blogs.reuters.com/felix-salmon/2012/07/18/whats-driving-the-total-return-etf/|url-status=dead|archive-date=July 20, 2012|access-date=26 March 2013|newspaper=Reuters|date=July 18, 2012}}</ref> This results in profits transferred from investors to algorithmic traders, estimated to be at least 21 to 28 [[basis point]]s annually for [[S&P 500]] index funds, and at least 38 to 77 basis points per year for [[Russell 2000]] funds.<ref name=Petajisto>{{cite journal|last=Petajisto|first=Antti|title=The index premium and its hidden cost for index funds|journal=Journal of Empirical Finance|year=2011|volume=18|issue=2|pages=271–288|doi=10.1016/j.jempfin.2010.10.002|url=http://www.petajisto.net/papers/petajisto%202011%20jef%20-%20hidden%20cost%20for%20index%20funds.pdf|access-date=26 March 2013}}</ref> In effect, an index, and consequently, all funds tracking an index are announcing ahead of time the trades that they are planning to make, allowing value to be siphoned by [[arbitrage]]urs, in a legal practice known as "index front running".<ref>{{cite web |url=http://www.thetradenews.com/1578 |title=Understanding index front running |access-date=2009-03-24 |work=The Trade Magazine |publisher=The TRADE Ltd. |archive-url=https://web.archive.org/web/20081023004716/http://www.thetradenews.com/1578 |archive-date=2008-10-23 |url-status=dead }}</ref><ref>{{Cite news|url=https://www.bloomberg.com/news/articles/2015-07-07/the-hugely-profitable-wholly-legal-way-to-game-the-stock-market|title=The Hugely Profitable, Wholly Legal Way to Game the Stock Market|newspaper=Bloomberg.com|date=7 July 2015}}</ref> Algorithmic [[high-frequency traders]] all have advanced access to the index re-balancing information, and spend large sums on fast technology to compete against each other to be the first—often by a few microseconds—to make these arbitrages. {{Dubious |reason=I don't think this particular arbitrage opportunity needs particularly fast technology, especially compared to other HFT algos|date=October 2016}} Losses to arbitrageurs appear as "tracking error", the difference between the performance of the index and the fund which is attempting to follow it.

John Montgomery of [[Bridgeway Capital Management]] says that the resulting "poor investor returns" from trading ahead of mutual funds is "the elephant in the room" that "shockingly, people are not talking about."<ref name=Montgomery>{{cite news|last=Rekenthaler|first=John|title=The Weighting Game, and Other Puzzles of Indexing|url=http://www.crsp.com/images/Reprint_Feb_Mar11MornignstarConversation_color.pdf|access-date=26 March 2013|newspaper=Morningstar Advisor|date=February–March 2011|pages=52–56|url-status=dead|archive-url=https://web.archive.org/web/20130729192302/http://www.crsp.com/images/Reprint_Feb_Mar11MornignstarConversation_color.pdf|archive-date=29 July 2013}}</ref> Related "time zone arbitrage" against mutual funds and their underlying securities traded on overseas markets is likely "damaging to financial integration between the United States, Asia and Europe."<ref>{{cite book|last=Donnelly|first=Katelyn Rae|author2=Edward Tower|title=Challenges and Opportunities for Trade and Financial Integration in Asia and the Pacific|publisher=United Nations Economic and Social Commission for Asia and the Pacific|year=2009|pages=134–165|chapter=Chapter VIII. Time-zone arbitrage in United States mutual funds: Damaging to financial integration between the United States, Asia and Europe?|chapter-url=http://www.unescap.org/tid/publication/tipub2563_chap8.pdf|series=Studies in Trade and Investment 67|location=New York|issn=1020-3516}}</ref>

===Common market impact===
One problem occurs when a large amount of money tracks the ''same'' index. According to theory,{{Clarification needed|date=October 2022}} a company should not be worth more when it is in an index. But due to supply and demand, a company being added can have a demand shock, and a company being deleted can have a supply shock, and this will change the price.<ref>{{cite web|url=http://www.iwu.edu/economics/PPE14/Malic.pdf |title=Market Reactions to Changes in the S&P 500 Index: An Industry Analysis |access-date=2014-07-30}}</ref><ref>{{cite web |url=http://www.finance.pamplin.vt.edu/faculty/vs/pdfs/2004JF-ChenNoronhaSingal-SP500Changes.pdf |title=The Price Response to S&P 500 Index Additions and Deletions: Evidence of Asymmetry and a New Explanation |access-date=2014-07-30 |archive-url=https://web.archive.org/web/20140606215238/http://www.finance.pamplin.vt.edu/faculty/vs/pdfs/2004JF-ChenNoronhaSingal-SP500Changes.pdf |archive-date=2014-06-06 |url-status=dead }}</ref> This does not show up in tracking error since the index is also affected. A fund may experience less impact by tracking a less popular index.<ref>{{Cite web |url=http://news.morningstar.com/articlenet/article.aspx?id=689924 |title=Small-Cap Indexing: Popularity Can Be a Pain |access-date=2015-03-26 |archive-date=2015-04-02 |archive-url=https://web.archive.org/web/20150402150257/http://news.morningstar.com/articlenet/article.aspx?id=689924 |url-status=dead }}</ref><ref>{{cite web|last=Arvedlund |first=Erin E. |url=http://online.barrons.com/news/articles/SB114384808690614031 |title=Keeping Costs Down - Barron's |publisher=Online.barrons.com |date=2006-04-03 |access-date=2014-07-30}}</ref>

===Possible tracking error from index===
Since index funds aim to match market returns, both under- and over-performance compared to the market is considered a "tracking error". For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the market.

According to [[The Vanguard Group]], a well-run S&P 500 index fund should have a tracking error of 5 [[basis point]]s or less, but a Morningstar survey found an average of 38 basis points across all index funds.<ref>{{cite news |first=Anne |last=Tergesen |author2=Young, Lauren |title=Index Funds Aren't All Equal |url=http://www.businessweek.com/magazine/content/04_16/b3879125_mz070.htm |archive-url=https://web.archive.org/web/20040426102207/http://www.businessweek.com/magazine/content/04_16/b3879125_mz070.htm |url-status=dead |archive-date=April 26, 2004 |work=[[BusinessWeek]] |publisher=[[McGraw-Hill Companies]] |date=2004-04-19 |access-date=2007-02-20}}</ref>
===Asset manager capitalism===
Benjamin Braun<ref name="Braun">{{cite journal |last1=Braun |first1=Benjamin |editor1-last=Hacker |editor1-first=J. S. |editor2-last=Hertel-Fernandez |editor2-first=A. |editor3-last=Pierson |editor3-first=P. |editor4-last=Thelen |editor4-first=K. |title=Asset Manager Capitalism as a Corporate Governance Regime |journal=American Political Economy: Politics, Markets, and Power |date=18 June 2020 |doi=10.31235/osf.io/v6gue |url=https://osf.io/preprints/socarxiv/v6gue |access-date=7 August 2024 |publisher=SocArXiv}}</ref> suggests that, since American stock ownership is concentrated on few big [[asset manager]]s which are very diversified and do not have a direct interest in the performance of the companies, this emerging "asset manager capitalism" is distinct from the earlier [[shareholder primacy]].
The asset managers usually vote with company managers.
Also, as funds invest in most companies in the sector, they would benefit from [[monopoly|monopolistic]] prices.
In an extreme case, there could be economy-wide monopolies where asset managers have "bought the economy".
In a regime of [[common ownership]], while asset ownership is diversified, it is a small part of the population who invest in funds and a top 1% of the wealth distribution owning 50% of [[corporate equity]] and mutual funds.
[[Wage stagnation]] would be an expected [[externality]].
Asset managers have an incentive to increase the assets value and influence [[monetary policy]].

==Diversification==
{{main|Diversification (finance)}}

[[Diversification (finance)|Diversification]] refers to the number of different securities in a fund. A fund with more securities is said to be better diversified than a fund with smaller number of securities. Owning many securities reduces volatility by decreasing the impact of large price swings above or below the average return in a single security. A [[Wilshire 5000]] index would be considered diversified, but a bio-tech [[Exchange-traded fund|ETF]] would not.<ref>{{cite web |url=http://www.vanguard.com/bogle_site/sp20040413.html |title=As The Index Fund Moves from Heresy to Dogma . . . What More Do We Need To Know? |access-date=2007-02-20 |last=Bogle |first=John C. |author-link=John Bogle |date=2004-04-13 |work=The [[Gary P. Brinson]] Distinguished Lecture |publisher=Bogle Financial Center |archive-url=https://web.archive.org/web/20070313082959/http://www.vanguard.com/bogle_site/sp20040413.html |archive-date=2007-03-13 |url-status=dead }}</ref>

Since some indices, such as the [[S&P 500]] and [[FTSE 100]], are dominated by large company stocks, an index fund may have a high percentage of the fund concentrated in a few large companies. This position represents a reduction of diversity and can lead to increased [[Volatility (finance)|volatility]] and [[financial risk|investment risk]] for an investor who seeks a diversified fund.<ref>{{cite web|url=http://www.spindices.com/documents/education/practice-essentials-equal-weight.pdf|title=Practice Essentials - Equal Weight Indexing|publisher=[[S&P Dow Jones Indices]]|access-date=2014-05-21|archive-date=2014-05-12|archive-url=https://web.archive.org/web/20140512223138/http://www.spindices.com/documents/education/practice-essentials-equal-weight.pdf|url-status=dead}}</ref>

Some advocate adopting a strategy of investing in every security in the world in proportion to its market capitalization, generally by investing in a collection of ETFs in proportion to their home country market capitalization.<ref>{{cite web|url=http://www.efficientmarket.ca/article/Globally_Efficient_Equity_Portfolio|title=Building a Globally Efficient Equity Portfolio with Exchange Traded Funds|access-date=2008-01-08|last=Gale|first=Martin|author-link=Martin Gale|archive-date=2018-11-16|archive-url=https://web.archive.org/web/20181116110450/http://www.efficientmarket.ca/article/Globally_Efficient_Equity_Portfolio|url-status=dead}}</ref> A global indexing strategy may have lower variance in returns than one based only on home market indexes, because there may be less correlation between the returns of companies operating in different markets than between companies operating in the same market.

==Asset allocation and achieving balance==
{{main|Asset allocation}}

[[Asset allocation]] is the process of determining the mix of [[stock]]s, [[Bond (finance)|bonds]] and other classes of investable assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts, and time horizon. Index funds capture asset classes in a low-cost and tax-efficient manner and are used to design balanced portfolios.

A combination of various index mutual funds or ETFs could be used to implement a full range of investment policies from low to high risk.

==Pension investment in index funds==

Research conducted by the [[World Pensions & Investments Forum|World Pensions Council (WPC)]] suggests that up to 15% of overall assets held by large [[pension fund]]s and national [[social security]] funds are invested in various forms of passive strategies including index funds, as opposed to the more traditional actively managed that still constitute the largest share of institutional investments<ref name="Rachael Revesz">{{Cite news|author=Rachael Revesz |title= Why Pension Funds Won't Allocate 90 Percent To Passives |url= http://europe.etf.com/blog/9450-why-pension-funds-wont-allocate-90-percent-to-passives.html |work=Journal of Indexes |date=27 November 2013 |access-date=June 7, 2014}}</ref> The proportion invested in passive funds varies widely across jurisdictions and fund type.<ref name="Rachael Revesz"/><ref name="Chris Flood">{{Cite news |author=Chris Flood |title=Alarm Bells Ring for Active Fund Managers |url=https://www.ft.com/content/22b03864-d535-11e3-9bca-00144feabdc0 |archive-url=https://ghostarchive.org/archive/20221210221252/https://www.ft.com/content/22b03864-d535-11e3-9bca-00144feabdc0#axzz33xgBDzEz |archive-date=2022-12-10 |url-access=subscription |work=FT |date=11 May 2014 |access-date=June 7, 2014 |url-status=live }}</ref>

The relative appeal of index funds, ETFs and other index-replicating investment vehicles has grown rapidly<ref>{{Cite news|author=Mike Foster|title=Institutional Investors Look to ETFs |url=http://media.efinancialnews.com/story/2014-06-06/institutional-investors-look-to-etfs?ea9c8a2de0ee111045601ab04d673622 |work=Financial News |date=6 June 2014 |access-date=June 7, 2014 |url-status=dead|archive-url=https://web.archive.org/web/20140715001220/http://media.efinancialnews.com/story/2014-06-06/institutional-investors-look-to-etfs?ea9c8a2de0ee111045601ab04d673622 |archive-date=15 July 2014}}</ref> for various reasons ranging from disappointment with underperforming actively managed mandates<ref name="Rachael Revesz"/> to the broader tendency towards [[cost reduction]] across public services and social benefits that followed the 2008–2012 [[Great Recession]].<ref name="europe.etf.com">{{Cite news|author=Rachael Revesz |title=UK Govt. Leading Way For Pensions Using Passives |url=http://europe.etf.com/europe/features-a-news/9778-uk-govt-leading-way-for-pensions-using-passives.html?start=1&Itemid=129 |work=Journal of Indexes - ETF.com |date=7 May 2014 |access-date=June 7, 2014}}</ref> Public-sector pensions and national [[reserve (accounting)|reserve]] funds have been among the early adopters of index funds and other passive management strategies.<ref name="Chris Flood"/><ref name="europe.etf.com"/>

==Comparison of index funds with index ETFs==
{{Globalize section|USA|date=December 2020}}
In the United States, mutual funds price their assets by their current value every business day, usually at 4:00&nbsp;p.m. Eastern time, when the New York Stock Exchange closes for the day.<ref>{{cite web|url=http://www.ici.org/funds/abt/faqs_navs.html |title=Frequently Asked Questions About Mutual Fund Share Pricing |access-date=2009-03-24 |work=[[Investment Company Institute]] |url-status=dead |archive-url=https://web.archive.org/web/20081026040912/http://www.ici.org/funds/abt/faqs_navs.html |archive-date=October 26, 2008 }}</ref> Index ETFs, in contrast, are priced during normal trading hours, usually 9:30&nbsp;a.m. to 4:00&nbsp;p.m. Eastern time. Index ETFs are also sometimes weighted by revenue rather than market capitalization.{{Cn|date=February 2025}}

== Tax considerations ==
=== International tax considerations ===
Typically mutual funds supply the correct tax reporting documents for only one country, which can cause tax problems for shareholders citizen to or resident of another country, either now or in the future.

==== Implications for US investors ====
US citizens/taxpayers living at home or abroad should particularly consider whether their investment in an ex-US fund (meaning the fund is administered by a foreign investment company) not providing annual 1099 forms (which report distributed income and capital gains/losses) or annual PFIC annual information statements will be subject to punitive US taxation under section 1291 of the US tax code. Note that if a PFIC annual information statement is provided, a careful filing of form 8621 is required to avoid punitive US taxation.<ref>{{cite journal
| last        = Gianni
| first       = Monica
| date        = 2014
| title       = PFICs Gone Wild
| url         = https://scholarship.law.ufl.edu/cgi/viewcontent.cgi?article=1628&context=facultypub
| journal     = Akron Tax J.
| volume      = 29 
}}
</ref><ref>
{{Cite web|url=https://www.irs.gov/instructions/i8621|title=Instructions for US form 8621}}
</ref>

=== U.S. capital gains tax considerations ===
U.S. 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 overall loss for the next six months. The mutual fund itself sold securities for a gain for the year, therefore must declare a capital gains distribution. The [[Internal Revenue Service|IRS]] would require the investor to pay tax on the capital gains distribution, regardless of the overall 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 redemption causing realized capital gains.

==See also==
{{Portal|Business}}
* [[Enhanced indexing]]
* [[Exchange-traded fund]]
* [[Passive management]]
* [[Stock market index]]

==References==
{{Reflist|30em}}
{{refbegin}}
* From [[Berkshire Hathaway]]'s 2004 Annual Report; see [[q:Warren Buffett|Wikiquotes]] for text.
* John Bogle, ''Bogle on Mutual Funds: New Perspectives for the Intelligent Investor'', Dell, 1994, {{ISBN|0-440-50682-4}}
* Mark T. Hebner, Foreword by [[Harry Markowitz]], [http://www.indexfundsbook.com ''Index Funds: The 12-Step Recovery Program for Active Investors''], IFA Publishing; Updated and Revised, 2015, {{ISBN|0976802317}}
* Taylor Larimore, Mel Lindauer, [[Michael LeBoeuf]], ''The Bogleheads' Guide to Investing'', Wiley, 2006, {{ISBN|0-471-73033-5}}
{{refend}}

==External links==
* [https://www.ivey.uwo.ca/media/3775539/is_stock_picking_declining_around_the_world.pdf "Is Stock Picking Declining Around the World?"]—The paper argues that there is a move towards indexing.
* [http://www.investopedia.com/articles/basics/03/032803.asp The Lowdown on Index Funds]—[[Investopedia]]'s introduction to index funds
* [https://ssrn.com/abstract=869748 False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas]—Evidence that stock selection is not a viable investing strategy.
* [https://www.nytimes.com/2008/07/13/business/13stra.html "The Prescient Are Few"]—"the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can't eliminate the possibility that the few that did were merely false positives"—''The New York Times''

{{Investment funds}}
{{Investment-management}}
{{Authority control}}

{{DEFAULTSORT:Index Fund}}
[[Category:Investment funds]]