The Index Fund

John (Jack) C. Bogle, founder and retired CEO of fund company Vanguard Group, died at the age of 89 in January 2019. A giant in the investment world, Vanguard Group manages around $5 trillion in assets1. Much like his friend and contemporary Warren Buffett, Jack strongly recommended a long-term approach centered on a buy and hold philosophy2. He was largely considered to be one of the greatest investors of all time involved in finance to the end; his final book was published in December 2018.

Bogle was known as the creator of the first index-based mutual fund available to individual investors. The First Index Investment Trust launched in 19763 and was designed to replicate the performance of the S&P 500. Derided and dismissed by much of the investment community, it was thought that any investment that didn’t strive to outperform markets was simply “un-americain” hence it’s nickname “Bogle’s Folly”.

Index funds are now one of the most popular investment products in existence.

What is an index fund?

An index fund functions like a mutual fund in that it is: a collection of stocks, managed by an individual or group, and trades in units. It is designed to replicate the performance of a specific financial index, including specific subsets of indices like market sectors. An index fund’s structure & holdings follows a set of “rules” that govern it’s management, much like a corporate charter.

Since it mimics the performance of any index as closely as possible, it is obviously an excellent product to hold in bull markets, but money will not be made during market downturns. That’s why an index fund is best used as a long-term investment tool and not intended for short-term investing.

Because the underlying stocks are not chosen but automatically selected to match the fund’s “charter”, index fund management is considered to be passive. So what distinguishes one, for example, S&P 500 index fund, from another? Aside from expense ratios and management effectiveness, like most conditions in life, it’s about the “weight”.

Market Cap, Equal, & Price weighted

Market Capitalization weighted or Value weighted is the total $ value of a company’s shares traded on the stock market. This is calculated by multiplying the total number of a company’s outstanding shares by market price. Simply defined, outstanding shares are all the shares in circulation not owned by the company itself. The total of all the shares owned by individuals, institutional investors, directors etc. make up outstanding shares or “the float”.

The index fund will be required to replicate the index which itself is weighted by market capitalization. This means the fund must purchase each stock in the index – and rebalance holdings as necessary – in proportion to each company’s market capitalization. Investment dollars into this fund will purchase more stocks of “large cap” companies and less of smaller ones. Therefore, the performance of the larger companies has greater effect on the index and, naturally, the index fund.

The S&P 500 index to which we most commonly refer and whose performance we see on most all financial sites, is a weighted index comprised of 500 large US companies in a variety of sectors. It is calculated by dividing the sum of the entire index market capitalization by a proprietary figure developed by Standard & Poors.

Index funds can also follow Equal weighted or Unweighted indices such as the lesser known S&P 500 EWI (Equal Weight Index). All the same companies as the regular index, but each company is allocated a fixed weight of 0.2% of the index total (the index is rebalanced quarterly.) This means an equal $ amount is invested in each company. Small and mid-sized companies determine performance since they are better represented

In a Price-weighted index, like the well-known Dow Jones Industrial Average (DJIA or the “Dow”), the addition of all the individual stock prices of each of the included US companies, divided by the number of included companies, equals the value of the index. At present, there are 30 companies included in the Dow, and stock prices are constantly adjusted to take into consideration, splits, mergers, acquisitions etc. which is why the math doesn’t add up for the average person. For a price-weighted index, the most expensive stocks determine performance and dollars invested in this type of fund will purchase more of the higher priced stocks because the expensive ones represent a larger fraction of the index.

While index funds are useful tools that can provide diversification in terms of markets and market sectors, both domestic and global, the structure of the funds themselves must be fully understood in order to be effectively deployed in any investment strategy. We don’t expect our clients to have this level of understanding, but we do like to educate and inform.

With over $6 trillion invested in index funds as of December 20184, our respect and hat-tip to Mr. Jack Bogle whose “folly” has had an undeniably massive impact on the modern financial landscape.


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