An Index by Any Other Name

An Index Fund is comprised of various holdings (stocks) that typically have very similar characteristics.

Most everyone has heard of the S & P 500 but not everyone knows what it is.  S & P stands for Standard & Poor’s, which is a financial services company (division of McGraw Hill) that publishes financial research and analysis on stocks and bonds.   To gain some perspective about their influence, on August 5, 2011 during the Great Recession, Standard and Poor’s downgraded the United State’s sovereign long-term credit rating from AAA to AA+.  Stocks plummeted between 5-7% right afterward because everyone thought the world would come to an end as a result.  It turns out that the market is pretty resilient and the world is still turning.

Standard & Poor’s has established indices to represent various sorts of stocks – typically measured by their size or, market capitalization.  The S & P 500 Index is composed of the largest 500 stocks in the United States.  There are numerous other companies and rating services that create and publish indices and there are indices representing a hundred different sorts of stocks – predominantly measured by their market capitalization in relation to all other stocks, but also sectors such as Health Care, Manufacturing, Financial Services, etc.  In my post about Diversification  I illustrated a chart with four sections to help visualize the characteristics of stocks – large, small, value and growth.  It follows that if stocks can be grouped into these “categories” that one could “be” the category by owning all of the stocks in that category. This is essentially what Mutual Fund managers do – they enable average investors to own all or most of a segment of the stock market by buying shares in their mutual fund – since it is not reasonable to think an individual investor has the ability to identify all those particular stocks or have the time or capital to buy all of them. A case in point is the Russell 2000 index which represents the smallest 2000 stocks in the United States.

While Index Funds are a great way for many investors to capture market returns, they do have inherent drawbacks that other, passively managed mutual funds do not have.  First, is the fact that an index can change.  A mutual fund tracking an index that swaps one stock for another must reconstitute itself to match the index.  Trading costs and unnecessary taxes are then generated.

I recently had the chance to attend a Symposium put on by Dimensional Fund Advisors, a large mutual fund company that only works with institutional investors (large corporations and pension funds), or, with professional advisors who adhere to Dimensional’s academically based philosophy which they call “Evidence Based Investing”.  See my blog post, It Was Only a Matter of Time, to learn more about this Nobel Prize winning approach.  It was good to hear from Dimensional, visit with their top people, and continue my education about the benefits of global diversification, low-cost passive management, asset class funds as compared to indices, and how to create a positive investment experience for my clients.

The Advance of Evidence-Based Investing

It didn’t take long before academically minded innovators from around the globe sought to improve on the best traits of index funds and eliminate their weaknesses. In fact, many of these thought leaders were the same early adopters who introduced index fund investing to begin with. The results are evidence-based investment funds, which offer us several advantages: 

  • Index-independence – Evidence-based fund managers have freed themselves from tracking popular indexes. Instead, they have established their own parameters for cost-effectively investing in the lion’s share of the securities within the asset class being targeted. This reduces the need to place undesirable trades at inopportune times simply to track an index; it allows them to employ more patient trading strategies and scales of economy to achieve better pricing.
  • Improved Concentration – Un-tethering themselves from popular indexes also enables evidence-based fund managers to more aggressively pursue targeted risk factors; for example, an evidence-based small-cap value fund has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund. This provides us with more refined control as we construct clients’ portfolios according to their individual risk/return goals.
  • Focusing on Innovative Evidence – We firmly believe that investors are best served when we make it a top priority to heed the evidence on how markets have delivered long-term wealth. Evidence-based investing shifts the emphasis from tracking an index, to continually improving our understanding of the market factors that contribute to the returns we are seeking. By building portfolios using fund managers who apply this same evidence to their fund constructions, we feel we can make best use of the academic insights we already know, while efficiently incorporating credible new ones as they emerge.

A Final Word: Investor Behavior

In many respects, the most important factor driving your investments has nothing to do with market factors. It has to do with your state of mind. To build or preserve sustainable wealth in ever-volatile markets calls for a disciplined outlook based on: (1) adhering to a long-term plan, (2) managing market risks and (3) minimizing the costs involved.


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  1. […] I have written about the S&P 500 and other indices before.  One post called, An Index by Any Other Name, goes into a lot of detail and also has links to other posts I have done on the subject of passive […]

  2. […] expense ratio on the mutual fund’s website or by searching online. See my prior posts, An Index by Any Other Name and Choosing an Investment Advisor.  A final word… A retirement plan is a great employee […]

  3. […] my recent post, An Index by Any Other Name I wrote about the characteristics of Index Funds.  Over the years academically minded innovators […]

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