What is an Index Fund?
The following was exerpted from the book from McGraw-Hill "Mutual Funds for the Utterly Confused" by Paul Petillo.
"John Bogle is often spoken of reverent terms and with good reason. His idea for indexing markets gave investors something they had not had prior to the introduction of his fund philosophy. To be able look into a fund and see what was going on was unheard of. Being able to see what a fund manager is doing is often referred to as transparency.
"People often make the mistake of confusing index funds with the market. They are not. In fact, index funds use indexes as benchmarks. The companies that publish benchmarks do so as a tracking device, a measure of performance. Vanguardıs 500 Index Fund and Extended Market Fund for instance track and index benchmarks published by Standard & Poors and the Wilshire company. Their Bond Market Fund, which as the first index for this corner of the market, uses the Lehman Brothers Aggregate Bond Index.
"And most importantly, not all indexes are created the same. As you saw earlier when we compared the performance of those early attempts at indexing, indexing requires more than just a dart thrown at the stock pages. The level of sophistication has not stopped as fund families and academics often hired to help, chart new areas to explore, new combinations to attempt, and with any luck, better overall performance."
Benchmarks and Indexes
An index is only as good as the benchmark it follows. The Charter Financial Analysts Institute or CFA holds the investment community to higher standards. Their mission statements reads: "Financial markets should be equitable, free, and efficient so that every investor has a chance to earn a fair return, the interests of the ultimate investor must take precedence over the interests of all other market participants," and "high ethical principles and self-regulatory standards are as important to market efficiency and fairness as rules and regulations."
This body of professionals standardized conduct among index funds and because of this code they are used as benchmarks for the actively managed mutual fund world we have just read about in the previous pages.
They felt an index should possess certain characteristics. Stability was extremely important to not only controlling fees that came from frequent trading but to maintain a passive voice. But the index would occasionally need to readjust based on how it was "weighted". Stability in a benchmark/index allowed the average investor to try to mimic the portfolio. Okay, the average investor with a lot of money.
This replication is important. Market participants should be able do the same thing as the index/benchmark does. How it strategizes should be something that can measured over time.
CFA also believed that the index should be relevant. Relevance has to do more with understanding. Investors can grasp why you would want to invest in the top 500 companies but not an index of the top pillow makers. Rules about barriers were created for international funds.
When was the first mutual fund created?
Back in the wild-west type days of our stock markets, there were no laws governing how securities were traded. This freedom led to wide-open manipulation of the markets as well as rampant speculation and a generous share of backroom dealings. Without any regulation, there was no one to trust. Each rumor could be fact and that meant the stocks could collapse on hearsay alone.
The first precursor of mutual funds was something called an investment trust. These were elegantly simple. Investors pooled their money and you were issued shares based on your investment. Once you had those shares, you could trade them on the stock exchanges just like you could stocks. Immediately, shady traders began to capitalize on something called free-float. It worked like this: An investment trust purchased stock on behalf of its shareholders. The value of those shares, which were also traded could be bought and sold for less than the value of the trust.
Suppose the trust was worth $100,000 in total stock. And suppose you owned one hundredth of that trust each share worth ten dollars. Suppose you wanted to sell all one hundred shares on the open market, but a bigger shareholder in the trust began suggesting that some company or another inside the trust was in financial trouble. Whether the rumor was true or not, your shares would no longer be worth $10 and might trade well below that price.
This change in the spread made small investors particularly vulnerable. Bigger investors would swoop in and buy the discounted shares. There are numerous other reasons these trusts gained a bad reputation as will any enterprise allowed to operate without concern for all of its investors, big and small.
Mutual funds were formally adopted in 1924. Three things made this the investment of choice among millions of investors from that point on. Because the fund only invested in common stock of publicly traded companies, investors could accurately calculate what each share of the fund was worth. Investment Trusts were able to borrow money, leveraging positions in certain companies; mutual funds were not permitted to do this. The vale of the fund would be calculated at the end of the day; not during the trading session.
That first mutual fund still exists.
Additional reading
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