Index Investing: The Basics

People often talk about passive versus active investing. Sometimes they talk about using index funds instead of actively managed funds. If you're new to investing, it's easy to get confused. So let's sort things out a bit.

By passive investing, we mean investing in a fund whose objective is to match the performance of an underlying market, or part of a market, as measured by some index. An index is a quantitative measure of the returns that have been earned by some underlying group of securities (be they stocks or bonds) over a fixed period of time. Most indexes are based on market capitalization weighting of the underlying assets. For example, if the market value of Security A was $100, and that of Security B was $20, the former would have five times the weight of the latter in the index.

Index Funds are vehicles through which individual and institutional investors can attempt to match the performance of an index. Index funds usually do not buy every underlying security in a given index; instead, they buy a selection of securities whose performance closely tracks that of the index as a whole. Because they do not engage in costly investment research, index funds usually have lower expenses than actively managed funds. Moreover, in most cases, because they trade less often than actively managed funds, index funds are also usually more tax efficient (that is, they generate fewer short and long term capital gains each year).

Index Funds come in two types: Exchange Traded Funds (ETFS) and Index Mutual Funds. ETFs are essentially index funds that are traded on a stock exchange. In contrast, an index mutual fund has to be purchased either through a broker or directly from the company that manages it. We discuss the differences between these two types of index funds more fully in the article titled: ETFs or Index Mutual Funds

By way of contrast, active management means investing with the objective of delivering returns that are greater than some "benchmark" index (also known as the "beta" return). This excess return is known as "alpha". This typically requires extensive research and/or some type of computer modeling. Actively managed funds are mutual funds which employ active management techniques, which cost more to implement than an indexing approach. For this reason, actively managed funds typically have higher annual management charges than index funds. Also, because active management often involves frequent trading of securities, actively managed funds often generate larger short and long term capital gains (and tax liabilities for their investors) than do index funds. If you want to continue to explore the differences between active and passive investing, please see Active Management or Indexing. For a more thorough review on the subject of "beta and alpha" returns, please see our article on Portable Alpha.

The Indexes Compared

Once you have decided to become an index investor, the next challenge you face is sorting through the large number of indexes that currently exist, and choosing between the funds that track them. To help you do this, we've developed a summary comparison of the major indexes you are likely to encounter.

Broad Market Indexes

Three major indexes attempt to cover all or most of the U.S. equity market:

The Wilshire 5000 index covers 100% of the public equity market

The Russell 3000 is based on the top 3,000 public companies in the public equity market, ranked by their market capitalization. Companies in the Russell 3000 recently accounted for 98% of the total market capitalization of the U.S. equity markets

The Dow Jones Total Market Index is based on a different approach. Whereas the Russell 3000 starts with a fixed number of companies, and varies the percentage of total market value covered, the DJTMI starts with a fixed percentage of total market capitalization (95%), and varies the number of companies included, so that its market capitalization coverage remains constant.

Large Cap Stock Indexes

Two of the most popular large capitalization stock indexes are the Standard and Poors 500 and the Russell 1000.

The five hundred companies included in the S&P 500 are chosen by Standard and Poors. The median market capitalization of companies included in the S&P was recently $8.6 billion. The companies in the S&P 500 recently accounted for 79% of total U.S. equity market capitalization.

The Russell 1000 includes the top 1000 companies (by market capitalization) from the Russell 3000. The median market capitalization of these companies was recently $4.1 billion. These companies recently accounted for 90% of U.S. equity market capitalization.

Mid Cap Stock Indexes

Two popular mid cap stock indexes are the S&P 400 and the Russell Midcap Index.

Companies in the S&P 400 are chosen by Standard and Poors. They recently had a median market capitalization of $1.9 billion. Taken together, they accounted for 6% of total U.S. equity market capitalization.

The Russell Midcap Index includes the 800 smallest companies in the Russell 1000 Index. These companies recently had a median market cap of $3.2 billion, and together they accounted for 22% of total U.S. equity market capitalization.

Small Cap Stock Indexes

There are three well known small cap stock indexes: the Russell 2000, the S&P 600, and the Wilshire 4500.

The Russell 2000 contains the 2000 smallest companies (by market cap) that are included in the Russell 3000 index. The median market cap of companies included in the index was recently $466 million. Together, these 2000 companies accounted for 8% of total U.S. equity market capitalization.

The six hundred companies included in the S&P 600 are chosen by Standard and Poors. Their median market cap was recently $502 million. Collectively, they accounted for 2% of total U.S. equity market capitalization.

The Wilshire 4500 includes all the stocks included in the Wilshire 5000, except those that are part of the S&P 500. The median market cap of these companies was recently $97 million, and together they accounted for 21% of total U.S. equity market capitalization.

Growth and Value Indexes

Both Standard and Poors and Russell produce growth and value subindexes for all their major index products. However, they do not use the same methodology for dividing companies into these two groups.

S&P simply divides the companies in each of its indexes into two equal groups, based on their respective Price/Book value ratios. Companies with relatively higher price/book ratios go into the growth index, and those with lower ratios go into the value index.

Russell not only considers price/book ratios in its determination of growth or value status, but also takes expected long-term earnings growth (based on IBES estimates) into account. Their weighting classifies 35% of companies as growth, 35% as value, and 30% as both (with equal weightings in both indexes).

International Indexes

Morgan Stanley Capital International (MSCI) produces the most widely used international country and regional equity indexes. Historically these indexes covered 60% of the total capitalization of their respective markets; they now cover 85%. Among the best known of the MSCI Indexes are its Europe and Pacific (Australia, Hong Kong, Japan, New Zealand, and Singapore) indexes (which cover developed countries in these regions), its EAFE index (a market capitalization weighted combination of the Europe and Pacific Indexes), and its Emerging Markets Index, which covers 28 developing country markets around the world. Other international index providers are the Financial Times/Stock Exchange (the FTSE Indexes) and Dow Jones.

Bond Indexes

The three major suppliers of bond indexes are Lehman Brothers, Salomon Smith Barney, and J.P. Morgan Chase.

In the U.S. market, Lehman Brothers produces the Aggregate Bond Index, which covers investment grade government, corporate, and asset backed securities across the maturity spectrum. Sub-indexes are available for short, intermediate, and long term maturities.

Salomon Brothers and J.P. Morgan produce very comparable world government bond indexes, which include bonds issued by developed country governments. J.P. Morgan also produces an Emerging Markets Bond Index.

For a more extensive discussion of investing issues we have raised here, please continue on to our free section titled: The Investment Management Process.

We hope this brief introduction to index investing answers your initial questions. To learn more, why not subscribe to The Index Investor today? Our goal is simple: to give you more value for your money than any other investment publication.

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