Debate on Indexing Heats Up
When the first index mutual fund was introduced 40 years ago by Vanguard, it opened with $11.3 million in assets. 1 Today, the Vanguard 500 Index Fund holds more than $252 billion, and index mutual funds and exchange-traded funds invest nearly $5 trillion in combined assets.2
Index funds are generally comprised of the same stocks or bonds in a benchmark index and tracks its buy and sell activity. As such, they do not require a lot of active management, and can offer lower fees than many other actively managed funds.3 However, while most actively managed funds aim to beat their benchmark index, the objective of an index fund is simply to match index performance.4
There are pros and cons to the indexing approach. In the positive column, index funds are a low-cost, diversified option in which investing decisions are passively managed. In the negative column, they do not offer as much flexibility in holdings, so a money manager can’t drop an underperforming stock or purchase an up-and-comer.5
When first launched, the very idea of index funds stunned money managers, and some critics called the approach “un-American.”6 That controversy was stoked again recently when one industry brokerage firm published a paper claiming that this form of passive investing “impedes the efficient allocation of capital.”7 The paper says by removing assets from active trading and artificially directing the flow of capital, indexing makes the market less efficient.8
Vanguard founder John Bogle came to the defense of indexing, pointing out the tremendous number of investors and assets these funds have brought to the markets. Indexing currently represents about 30 percent of the market.9
There recently have been a number of lawsuits filed against 401(k) plan sponsors that have overcharged for index fund options. One index fund was charging 35 basis points for a fund similar to Vanguard’s, which charged two basis points.10 In a recent ruling, the Supreme Court admonished plan sponsors about their responsibility to monitor fees charged by investment managers.11
While index funds may not influence pricing fundamentals for individual securities, they have been quite influential in pricing management fees. For example, the average fee for active funds has dropped from .99 percent in 2000 to .77 percent today, which translates into even non-index investors saving about $200 billion in active funds during that time frame.12
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1 Jason Zweig. The Wall Street Journal. Aug. 31, 2016. “Birth of the Index Mutual Fund: ‘Bogle’s Folly’ Turns 40.” http://blogs.wsj.com/moneybeat/2016/08/31/birth-of-the-index-mutual-fund-bogles-folly-turns-40/. Accessed Sept. 9, 2016.
3 Tom Anderson. CNBC. June 26, 2015. “Index funds trounce actively managed funds: Study.” http://www.cnbc.com/2015/06/26/index-funds-trounce-actively-managed-funds-study.html. Accessed Sept. 21, 2016.
4 Jason Zweig. The Wall Street Journal. Aug. 31, 2016. “Birth of the Index Mutual Fund: ‘Bogle’s Folly’ Turns 40.” http://blogs.wsj.com/moneybeat/2016/08/31/birth-of-the-index-mutual-fund-bogles-folly-turns-40/. Accessed Sept. 9, 2016.
5 Zacks. “What Are the Primary Advantages & Disadvantages of Index Mutual Funds?” http://finance.zacks.com/primary-advantages-disadvantages-index-mutual-funds-4030.html. Accessed Sept. 21, 2016.
6 Jason Zweig. The Wall Street Journal. Aug. 31, 2016. “Birth of the Index Mutual Fund: ‘Bogle’s Folly’ Turns 40.” http://blogs.wsj.com/moneybeat/2016/08/31/birth-of-the-index-mutual-fund-bogles-folly-turns-40/. Accessed Sept. 9, 2016.
7 Luke Kawa. Bloomberg. Aug. 23, 2016. “Bernstein: Passive Investing Is Worse for Society Than Marxism.” http://www.bloomberg.com/news/articles/2016-08-23/bernstein-passive-investing-is-worse-for-society-than-marxism. Accessed Sept. 9, 2016.
9 Charles Stein. Bloomberg. Sept. 9, 2016. “Bogle Says Index Investing Is No Threat to Market Efficiency.” http://www.bloomberg.com/news/articles/2016-09-09/bogle-says-index-investing-is-no-threat-to-market-efficiency. Accessed Sept. 9, 2016.
10 Suzanne Woolley. Bloomberg. July 22, 2016. “Off on Index Fund Fees, Lawsuits Say.” http://www.bloomberg.com/news/articles/2016-07-22/investors-are-getting-ripped-off-on-index-fund-fees-lawsuits-say. Accessed Sept. 9, 2016.
12 Eric Balchunas. Bloomberg. Aug. 30, 2016. “How the Vanguard Effect Adds Up to $1 Trillion.” https://www.bloomberg.com/view/articles/2016-08-30/how-much-has-vanguard-saved-investors-try-1-trillion. Accessed Sept. 9, 2016.
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