In the 1970s, firms like Vanguard began offering passively managed index funds to U.S. investors. Unlike actively managed funds, index funds don't try to beat the stock market. Instead, they mimic the entire market or certain market segments with low operating expenses, low turnover, and diversification. Studies show that indexing approaches outperform many actively managed approaches over the long-term. Consequently, investors already have trillions of dollars invested through traditional index investment strategies like Vanguard and more recently many ETFs (or exchange traded funds) as well.
The idea of implementing an index fund (also called passive) approach to investing developed because some academics in the 1960s and 1970s started to use computers to study historical asset pricing data for the first time. They soon realized that predicting the short-term prices of investment assets in liquid public trading markets was very hard -markets mostly do a reasonable job based on the information available at hand. They also realized that the vast majority of investors do not manage to beat the market averages over the long-run. Specifically, over 10 year periods, as many as 75 to 80% of all funds and active investors who try to beat the market fail to do so. While this means that 20 to 25% of professional investors do beat the market, most investors find it difficult or impossible to identify who the winners will be upfront - past performers don't always repeat their winning ways in the future.
Still, most investors think that they will be the exception to the rule (researchers have demonstrated that people are consistently over-optimistic - ask a room full of average people if they consider themselves to be above average drivers and more than 80% of hands will go up). The hard data however suggests that many investors might be better off to admit that their odds of beating the market are low. One alternative would then be to just invest in the market averages. Since the market components do not change that frequently, this type of "market indexed" portfolio would also have low costs, low trading and good tax-efficiency. In essence, indexing is a buy-and-hold approach where the companies held represent the market as a whole (and later to include certain sub-segments as well).
The early index funds were based on widely known and followed market averages or indexes, most notably the S&P500. The origins of the S&P500 begin as early as 1923 with 233 companies in 26 industries. In the modern version, there are 500 companies which are selected to represent the major components of the economy and the stock market. Each company in the index is assigned a percentage (based on its overall size). An index fund tracking the S&P500, for example, would attempt to simply own these 500 companies in the proportions necessary to match this index as closely as possible.
Remember, however, an index fund does not try to beat the market, but only replicate the market though a diversified ownership of hundreds or thousands of companies that are part of the index that the fund is seeking to replicate. This focus on tracking instead of beating/performing is why newer enhanced indexing approaches may offer smart investors a superior alternative to traditional indexing.
Innovations in indexing have creating powerful new tools - but most investors don't know about them
While the number of index funds has exploded in the last 15 years, most traditional index funds use the same basic approach they used more than 30 years ago. In many fields, new innovations and technology are creating powerful new tools and options so you should not be surprised to know that recent innovations now enable sophisticated investors and advisors to use enhanced index fund strategies that offer compelling advantages over traditional index funds. Since traditional indexing is already superior to many other approaches, enhanced indexing is a powerful option. Properly used it could meaningfully enhance your current portfolio. Unfortunately, most investors have never heard of enhanced indexing.
Differences between traditional and enhanced approaches to indexing
Like traditional index funds, enhanced index funds offer the advantages of low operating costs, low turnover, and diversification. However, they also utilize a variety of additional enhancement strategies. Though specifics vary, some of the more common enhancement strategies include:
- Index Construction Enhancements - Instead of relying on external indexes created by third parties like S&P or Dow Jones, enhanced index managers often create their own indexes and use different strategies to optimize them for better performance.
- Exclusion Rules - Some enhanced indexes eliminate securities likely to reduce performance that would be otherwise included in traditional indices (e.g. companies with excessive debt or those in bankruptcy).
- Trading Enhancements - Utilizing intelligent trading algorithms, some enhanced index funds create value through trading (e.g. by buying illiquid positions at a discount or by selling more patiently than traditional index funds).
- Portfolio Construction Enhancements - Enhanced index funds sometimes implement so-called 'hold' ranges that reduce portfolio turnover by allowing funds to hold positions during buffer periods even after traditional index fund sell signals have been triggered.
- Purer Asset-Class Strategies - Enhanced index funds may offer a greater selection of focused asset classes including value-oriented, micro-cap, and international strategies (e.g., a low-cost international small-cap value strategy). Implementing a value investing approach through enhanced indexing has been a particularly powerful combination in the past (see www.indexvalue.com).
- Tax-Managed Strategies - Among the newest enhancements, tax-managed index funds manage buys and sells to minimize taxes. These tax-managed index funds can be superior to many variable annuities for tax-efficient wealth creation.
Certain enhanced index funds are available to the public (for example through ETFs) while others, like the outstanding no-load low-cost enhanced index funds offered by Dimensional Fund Advisors (www.dfaus.com), are available only though a select group of fee-only advisors. You can use enhanced indexing either on a stand-along basis or as one component of a larger portfolio that also incorporates other strategies. Properly used, enhanced indexing can be an excellent foundation, particularly for defined benefit retirement/pension plans where the goal is long-term wealth preservation and growth.
Now that you now know about enhanced indexing, you already have a head start compared to most people who have never heard of this powerful investment strategy. How much difference can this knowledge make? The better enhanced indexing strategies have outperformed their traditional index counterparts by 1% to 3% per year or more. With compounding, this difference really adds up (over 30 years a 3% advantage would more than double the amount of money you will have). So whether you implement it on your own or with the help of a skilled advisor, enhanced indexing can make a major contribution to your personal and financial freedom.