Indexes 101, Part 3: The Birth and Evolution of Index Investing

 

According to legend, a pharmacist by the name of John Pemberton was looking for a cure for the headache when he first tried blending Coca leaves with Cola nuts. Pemberton couldn’t have known this recipe would eventually reach the heights of fame, even though Coca-Cola® never ended up achieving his original goal.

This story has a lot in common with how Charles Dow launched the Dow Jones Industrial Average (the Dow). His goal at the time was to develop a way to better assess stock prices and market trends, with an eye to figuring out when the markets were experiencing a sea change, by taking stock of the incoming and outgoing “waves.” His reason for choosing industrials (mostly railroads) was in line with his 1882 proposal: “The industrial market is destined to be the great speculative market of the United States.”

It’s fair to say that Dow was never able to devise a market-timing crystal ball (no one has), but he did end up creating the world’s first stock index. The significance of his creation stretched beyond anything he ever imagined, eventually allowing Vanguard founder John Bogle and others were able to leverage it to create one of the most powerful ways to invest: the index fund.

The first publicly available index fund was launched by Bogle in 1976[1]. At first it was dismissed by many as “Bogle’s folly,” and “un-American.” It has evolved to become the Vanguard 500 Index Fund, one of the most well-known funds around today.

The Birth of Index Investing

To be fair to Dow’s desire to peer into the future of market movements, we should keep in mind that in his day, electronic ticker-tape was cutting edge technology. On top of that, open-ended mutual funds and fee-only financial advisors didn’t exist, and safeguards and regulations were pretty much nil. In other words, speculating about the future was pretty much the only way a person could invest in markets at the time.

Of course, when you compare the same old, outdated speculative strategies of actively managed funds that try to “beat” the market with passively managed index funds, you’ll find the latter have a more stable, reliable track record of capturing market returns. As you might guess from the name, index funds buy and hold securities tracked by a particular index that is trying to represent the performance of a specific slice of the market. For example, the Vanguard 500 Index Fund tracks the ever-popular S&P 500 Index, which then tracks the asset class of U.S. large-company stocks.

When you compare them with actively managed options, index funds seem to be better suited to help investors to accomplish these three pillars of sound investing:

1. Asset allocation – How you allocate your portfolio across various market asset classes plays a much bigger impact on varying your long-term portfolio performance than any individual securities you hold.
2. Global diversification – With broad and deep diversification, the sum of your total risk is often lower that its individual parts.
3. Cost control – Simply put, the less you spend on implementing a strategy, the more you get to keep for yourself.

Index Investing: In Need of Improvement

As we’ve discussed earlier in this series, indexes weren’t originally designed to be invested in. A lot of the time, beneath the simple exterior lurk complexities that can turn into inefficiencies when somebody tries to force their investment products into the mold of popular indexes.

Index Dependence

Any time an index “reconstitutes” by changing out the underlying stocks it is following, any funds tracking the index need to change their holdings as well, and quickly if they hope to remain true to their stated goals.

This can turn into a textbook example of supply-and-demand pricing, by creating a “buy high, sell low” environment as index fund managers scramble to sell the stocks that have been removed from the index and buy the ones that have been added.

Compromised Composition

Asset allocation is based on the idea that certain market asset classes exhibit specific risk and return characteristics over time. That’s why you want your investments to be managed carefully, to include the right asset class portions to match your financial goals and risk tolerances.

In our previous installment, we described how you can end up with off-sized “slices” of your investment “pie” if you’re invested in an index fund and you don’t know exactly what its underlying index is tracking.

Take a look at the S&P 500 and the Russell 3000, for example. Both are positioned as U.S. stock market indexes, but each of them also tracks real estate. If this important information doesn’t get factored into your plans, you might end up with a much bigger “slice” of real estate than you wanted.

Introducing Factor-Based Investing

Yes, index investing definitely has its advantages…but it also has its own set of challenges built-in. This explains why some of the best minds in the world of investing wanted to improve on the better qualities of index investing, and simultaneously sought to minimize its weaknesses.

Many of those same leading innovators were the same ones to introduce index fund investing early on. Building on the foundation of index investing, these pioneers created factor-based investment funds, which have their own advantages to offer:

Index-independence

How about instead of tracking an index that tracks an asset class, we simply capture the asset class itself as effectively as possible? Factor-based fund managers are freed from tracking popular indexes because they’ve established their own parameters for cost-effective investing in most of the securities within the asset classes they have targeted. What this does is reduce the need to trade unnecessarily and at the wrong time, just to track an index. It also serves to allow for more patient trading strategies and scales of economy to form and ultimately achieve better pricing.

Better Concentration

By being freed from popular indexes, factor-based fund managers are able to pursue more aggressively targeted risk factors; a factor-based small-cap value fund, for example, will have more flexibility to hold smaller and more value-tilted holdings than a comparable index fund would. This gives more precision and control for building up your investment portfolio according to your personal risk/return goals.

Focusing on Factors that Innovate

Factor-based investing changes the focus from tracking an index to better understanding the exact market factors that will bring about the returns we’re looking for. When you build a portfolio using fund managers who use and apply these same factors to their funds, you can leverage pre-existing academic insights while incorporating new information as it emerges.

Index Overview, Taking Another Look

We’ve covered a lot in this series! As we bring it to a close, let’s review the major points:

• Indexes are helpful when you want to see what’s going on within one particular slice of our capital markets.
• Under the right circumstances, they can be a real help when comparing your own investment performance against a common benchmark.
• Lastly, you can invest in funds that track particular indexes, too.

Just keep in mind that indexes do not allow us to peer into the future. They can’t tell you what’s happing next in the markets. Nothing and no one can. While it’s true that low-cost, well-managed index funds might make a great addition to your investment portfolio, you want to make sure you only select them when they’re the right fit for your factor-based investment strategy, and not just because they’re the popular thing at the moment.

Want to learn more about how you can use index investing to your advantage? .

[1] Having worked at Dimensional Fund Advisors previously, I feel compelled to point out that both of the founders of Dimensional separately started non-publicly available index funds in 1973. We now return you to the non-petty portion of this article…