Index funds and many ETFs share the goal of tracking market indices, such as the FTSE 100 Index, rather than outperforming them. However, not all ETFs are passive, and many index funds are structured as mutual funds.
- Index funds can be structured as either mutual funds or ETFs. They aim to replicate the performance of a specific market index rather than attempting to beat it.
- While most ETFs are designed to passively track indices, some are actively managed where fund managers make investment decisions seeking to outperform a market index.
- A large proportion of mutual funds are actively managed, with portfolio managers seeking to outperform their benchmark index.
- Index funds have continuously gained market share over actively managed funds.
The Origins of Index Funds
Index investing dates back to August 31, 1976, when Jack Bogle, the founder of Vanguard Group, launched the first index fund replicating the S&P 500 Index. His "buy and hold" index strategy, a stark contrast to traditional stock-picking methods, caused a stir in the financial industry. Bogle's goal was to simplify investing, making it accessible to everyone—a mission that index funds have successfully fulfilled.
Key Milestones in the History of Index Investing, Starting with the Launch of the First S&P 500 Index Fund
1973
Burton Malkiel publishes A Random Walk Down Wall Street, advocating for passive investing.
1975
Wells Fargo creates the first S&P 500 index fund for institutional investors.
1976
John Bogle launches the Vanguard 500 Index Fund, the first retail S&P 500 index fund.
1984
Milton Friedman publicly supports index investing.
1986
Introduction of the Wilshire 5000 Index, tracking nearly all U.S. publicly traded stocks.
1988
Vanguard launches its first international index fund.
1990
Vanguard introduces the Total Stock Market Index Fund.
1993
SPDR S&P 500 ETF (SPY), the first ETF, is launched.
1996
Vanguard introduces tax-managed index funds.
2000
ETF market expands to include sector-specific and international funds.
2003
iShares launches the first bond index ETF, iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).
2004
Sector ETFs gain popularity, offering exposure to specific industries.
2010
"Smart beta" ETFs, targeting specific factors, become widely available.
2016
U.S. index fund and ETF assets surpass those in actively managed funds.
2018
Fidelity launches zero-fee index funds.
2020
Index funds and ETFs own about 20% of the U.S. equity market.
2021
Global ETF assets surpass $10 trillion.
Source: Morningstar, Bloomberg.
The Case for Passive Investing
Understanding Market Efficiency and the Limits of Active Management
A key theory underpinning passive investing is the Efficient Market Hypothesis (EMH), which suggests that especially in large, developed markets, security prices quickly reflect all available information. This makes it extremely difficult for active investors to consistently outperform the market by finding undervalued stocks. While active fund managers argue that markets are not entirely efficient and that skilled teams can exploit price discrepancies, the data suggests otherwise.
Percentage of active funds that have outperformed the S&P 500 benchmark
% of funds that outperformed benchmark (S&P 500 vs U.S. Equity)
Source: Spiva, June 2024
Key findings:
- 1-year performance: 26% of active funds outperformed the S&P 500, suggesting some short-term success.
- Long-term decline: Only 4% of funds outperformed over 3 years, 7% over 5 years, and just 3% over 10 years.
- Market efficiency: The low percentages highlight the difficulty of consistently outperforming in efficient markets, supporting the Efficient Market Hypothesis.
The Mechanics of Index Funds
Tracking an Index with Precision
An index fund is managed to replicate the performance of a specific market index. These funds track an index with regular rebalancing to ensure minimal tracking differences. Rebalancing adjusts for changes in the index, such as correcting the weight of stocks that have grown too large or removing stocks that are no longer part of the index.
Indices are updated regularly, and fund managers strive to accurately reflect these changes in their index funds. For instance, if a stock’s weighting in the index changes, or if it is removed altogether, the fund manager adjusts the fund accordingly to ensure it remains aligned with the index over time.
However, tracking differences can occur due to several factors, including:
Higher ongoing fees can make it harder for a fund to track the index closely. Over time, a tracking difference occurs in line with the fees levied.
Most jurisdictions levy a withholding tax on dividend payments. The tax might be (partially) reclaimed depending on the fund’s domicile and whether there are bilateral tax treaties in place. Tracking differences occur based on where the fund is based for tax purposes and the way the index deals with withholding taxes. The following points are relevant:
- A gross total return index assumes zero withholding taxes.
- A net total return index assumes a specific withholding tax rate, which might not necessarily perfectly correspond with that of the fund.
Fund managers may hold some cash for management purposes, which can affect how closely the fund tracks the index. On days that markets go up, a cash holding will lead to a negative tracking difference and vice versa.
Corporate actions, such as dividend payments, spin-offs and M&A can lead to tracking differences to the extent that the portfolio cannot perfectly mirror the processing of said corporate action in the index calculation:
- Dividend payments: Typically, an index assumes a dividend to be paid at the day the stock goes ex-dividend. In practice, the money typically is only received a few days later.
- Share buy-backs: Often the weight of a stock in an index is based on the free-float market capitalization. A share buy-back leads to a reduction of a company’s free-float market capitalization, a fund manager typically participates pro-rata in the buy-back. However, timing differences can lead to a small tracking difference.
- Acquisitions: if a company is acquired by another company, which is not part of the index, the fund manager will receive cash or stocks which need to be reinvested. Typically, this leads to timing differences with the index adjustments.
To reduce transactions costs (which would negatively influence the fund’s performance), a fund manager may decide not to 100% exactly replicate the index:
- Allow small weight deviations in the portfolio compared to the index in order to reduce the turnover in the portfolio.
- Decide not to fully replicate the index but only buy a selection of securities which should replicate the overall performance of the index. This practice is referred to as ‘sampling’. It is mostly used with funds which invests in a large number of securities, or funds which invests in securities with large values, such as most fixed income funds.
Index funds are often referred to as tracker funds because they track an index.
Why Choose Index Funds?
Lower Costs and Performance that Matches the Benchmark
One of the main advantages of index funds is their low fees compared to active funds. This is because index funds require fewer resources—no need for fund managers, extensive research, or frequent major portfolio transactions. Over time, these lower management costs can have a substantial impact on returns. For instance, paying just 0.5% in annual fees versus 2% can nearly double your capital over 30 years, assuming a consistent 6% return.
Evolution of €10k invested with different fees
Source: VanEck.
The Active vs. Passive Debate
Why Most Active Funds Fail to Beat the Market
While active managers often assert outperformance, data shows that many active funds struggle to match the returns of efficient market. Earlier on this page, we have shown that very few active managers outperform over long periods of time. However, it also holds for shorter time horizons, if to a lesser degree. Data from S&P Dow Jones Indices shows that since 2001, an average of 65% of large-cap US equity funds have underperformed the S&P 500 each year.
Percentage of U.S. large cap equity funds underperforming the S&P 500 each year
Source: S&P Dow Jones Indices, March 2024.
The Rapid Rise of Passive Investing
How Index Funds Are Becoming the New Standard
Probably as a result of their relative advantages over actively managed funds, index funds have seen strong growth in AUM. Over the past decade, passive investments’ assets have grown at a compound annual growth rate of around 9%, with nearly half of all global funds now adopting a passive approach.
Assets in passive equity funds have overtaken assets in active equity funds
Source: LSEG Eikon. Data refers to funds globally.
Also based on number of funds, passive has overtaken active for equity funds. For fixed income, index funds are still the minority, but the share is rising.
The Challenges of Adopting Index Funds
Understanding the Barriers to Passive Investing
One reason not everyone uses index funds is their relative novelty. Although index funds are gaining traction, it takes time for new investment strategies to become fully mainstream. Historically, many financial advisors recommended active funds because they were more profitable, either through higher fees or advisors’ commissions. However, new regulations like the EU's MiFID II have been designed to align advisors' interests with those of their clients, leading to a rise in index fund sales as fee structures become more transparent.
Potential Drawbacks of Index Funds
While index funds offer many advantages, they are not without limitations:
- Lack of Flexibility: Index funds are designed to track an index and cannot adjust holdings to take advantage of market opportunities or avoid downturns.
- Market Risk: Index funds are fully exposed to the market's movements. During a downturn, they can experience significant losses, as they mirror the performance of the overall index.
- Limited Customization: Investors looking for tailored portfolios may find index funds too generic, as they follow predefined benchmarks without accommodating specific financial goals or ethical preferences.
- Overconcentration Risks: Some indices are heavily weighted toward a few large companies or sectors, which can lead to imbalanced exposure in the fund.
As index funds become a dominant instrument in the investment world, understanding their workings and benefits can help investors to make informed, cost-effective choices. To learn more about a specific kind of index fund or ETF follow our next Academy course.