Equity index funds would include groups of stocks with similar characteristics such as the size, value, profitability and/or geographic location of the companies.
[4]: 4 Investors, academicians, and authors such as Warren Buffett, John C. Bogle, 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.
From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in new net cash, including reinvested dividends.
In contrast, actively managed domestic equity mutual funds experienced a net outflow of $659 billion, including reinvested dividends, from 2007 to 2014.
[7][8][9] The first theoretical model for an index fund was suggested in 1960 by Edward Renshaw and Paul Feldstein, both students at the University of Chicago.
Beach (BSBA Banking and Finance, University of Florida, 1957) and joined by Walton D. Dutcher Jr., filed a registration statement (2-38624) with the SEC on October 20, 1970 which became effective on July 31, 1972.
[citation needed] In 1973, Burton Malkiel wrote A Random Walk Down Wall Street, which presented academic findings for the lay public.
...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....
[11]John Bogle graduated from Princeton University in 1951, where his senior thesis was titled The Economic Role of the Investment Company.
[14] Fidelity Investments Chairman 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".
[citation needed] 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.
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.
"[16] In 1981, Booth and Sinquefield started Dimensional Fund Advisors (DFA), and McQuown joined its board of directors.
Economist Eugene Fama said, "I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information."
[19][full citation needed] Economists cite the efficient-market hypothesis (EMH) as the fundamental premise that justifies the creation of the index funds.
Note that return refers to the ex-ante expectation; ex-post realisation of payoffs may make some stock-pickers appear successful.
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.
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.
[21][22] This allows algorithmic traders (80% of the trades of whom involve the top 20% most popular securities[21]) to perform index arbitrage by anticipating and trading ahead of stock price movements caused by mutual fund rebalancing, making a profit on foreknowledge of the large institutional block orders.
[26][27] 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 – discuss] 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.
"[28] 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.
This position represents a reduction of diversity and can lead to increased volatility and investment risk for an investor who seeks a diversified fund.
Asset allocation is the process of determining the mix of stocks, 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.
[39][40] The relative appeal of index funds, ETFs and other index-replicating investment vehicles has grown rapidly[41] for various reasons ranging from disappointment with underperforming actively managed mandates[39] to the broader tendency towards cost reduction across public services and social benefits that followed the 2008-2012 Great Recession.
Note that if a PFIC annual information statement is provided, a careful filing of form 8621 is required to avoid punitive US taxation.