Index Investing: Track the Market with Passive Strategy

More and more institutional investors, especially pension funds, are applying index-investing strategy by shifting their assets from active managers to index funds.

SmartInMoney reported, there are four major attractions of indexing that motivate investors to track market performance, rather than try to outperform it.

1. They offer a remarkably simple, convenient way to create a diversified portfolio.
2. Index funds typically cost less to manage than actively managed funds.
3. Their performance track record has been impressive, even during bear markets.
4. Index funds are fully invested strategy that keeps investor staying in the game during market recover

Simple

Indexing is a very simple way of gaining exposure to an investment style or the broad market. Index funds can help investors to build a portfolio that's appropriately diversified to meet investors’ goals, time horizon, and tolerance for risk in a convenient way.

Low Cost

Index funds’ main advantage is lower cost than investors would get from an actively managed mutual fund. Index funds win in all three components of investment cost.

Index funds charge low expense ratio, which is the cost of managing the fund. An average non-index fund has an expense ratio of around 1.5%; whereas many index funds have an expense ratio somewhere between 0.15% to 0.5%. Index funds are not actively managed; they are managed largely using computer programs. There are no expensive analysts required to try to figure out what bets to take.

Index funds transaction costs are generally much lower. The costs are incurred as the portfolio manager is managing the portfolio. Indexing is a very low-turnover strategy, relatively low compared to active management. While active strategy involves relatively frequent buying and selling securities, index fund managers only need to maintain the appropriate weightings to match the index performance; the technique is known as passive management.

The third cost is associated with taxes, in the form of capital gains or taxes on dividends. Passive management generates realized capital gains from trading far less frequently than does active management. Consequently, more tax payments could be either deferred of avoided entirely.

What matters to investors are after-cost returns. A fund's return is the total return of the portfolio minus the fees an investor pays for the investment costs. If a fund charges 1.5%, then the portfolio manager have to outperform the fund’s benchmark by that amount just to be even. Anything less, and the fund's returns would lag its benchmark. Studies reveal main culprit for the failure of actively managed funds to beat the indexing is the high costs that they charge. The more you trade, the less you earn, because management fee, transaction costs, taxes and bad decisions always kill returns

Hard-to-Beat Performance

Historically, index funds have performed very competitively against actively managed funds, and frequently outperforming a majority of active funds whether it's a shorter time period, like a year, three years, five years, or extending out ten years.

Over the year 2008, which was a very difficult year in the marketplace, index funds still outperformed a majority of the actively managed portfolios. Over the same period of time, index fund performance was very competitive against the active investments in different segments within the marketplace. In the nine Morningstar "style boxes," such as large-cap value or large-cap growth, indexing outperformed active managers in three of those, according to Gus Sauter, Vanguard's chief investment officer. It underperformed in three, and matched the active managers in three.

Over longer time periods, index funds provided even more competitive performance because that's where the costs of active management get compounded over time. So investors tend to find that over a 10-year (or more) time horizons, most indexes have outperformed the active investments.

Recent studies provided more evidence that the failure of active management in beating their benchmark index is replicated across almost all categories, not only U.S. stock funds but also bond funds and even emerging-markets funds. What's more, a new study found that it is very hard, if not impossible, to justify active management for most individual, taxable investors over a long term. (Detail findings of the studies are elaborated in the "Index Investing Supremacy")

Investing in an index fund doesn't guarantee that you'll never lose money. Index funds will decline in a bear market and up in a bull market, right along with the market. Investors should really think long-term because indexing is a great way to capture the long-term returns of the marketplace with its low-cost benefit. If investors get nervous during a downturn and sell, they’ll probably miss the recovery.

Fully Invested

Index investing can be a great way to capture the typically fast burst that a market experiences when it's making the shift from a bear market to a bull market. A fully invested strategy of index investing positions investors very well to benefit from the large rate of return during the market recovery. It's designed to perform right in line with the market as it goes up. In the last five or six bear markets, particularly the very steep bear markets, the market typically had a very large increase in the first 12 months coming out of a bear market (read "One year after the bear").

Market just witnessed that after months of the most recent cruel bear market, which bottomed in March, the stock markets closed the third quarter ending Sept. 30. 2009 with huge gain and the Dow Jones Industrial Average reclaimed the 10,000 mark on Oct. 14, 2009.

As a bear market turns into a bull market, active managers may suffer from a couple of problems as a bear market turns into a bull market. First, the active managers tend to hold the most cash near market bottoms. Because of the cash drag in an actively managed portfolio, it won't fully benefit in the rebound.