Barclays Global Investors ("BGI") invented indexing with the creation of the first indexed strategy in 1971. Since then, indexing has become a popular investment technique among institutional investors in most developed markets.
For individual investors, however, indexing is a relatively new concept. While they may have heard of indexing, or read about it in the business press, individual investors may not always realize just how compelling the case for indexing is. Highlighted below are some of the reasons why indexed investment strategies have experienced remarkable growth in the past three decades:
Index funds are easy to understand and manage. With index funds, you can focus on the risk/return tradeoffs of different asset classes, instead of trying to second-guess the investing styles of different managers. You can make informed decisions and feel more comfortable about your choices.
Index funds generally charge lower investment management fees. This is because index fund managers aren't spending time and resources researching and visiting individual companies. Also, index managers only trade stocks when there is a change in the index. This means that they have lower transaction costs than active managers, who may be trading frequently as markets move. All else being equal, lower fees translate into higher returns.
Index funds are broadly diversified since they typically hold all securities in an index. This diversification helps reduce risk.
Distinct asset classes
A variety of studies have shown that trying to time the market or pick winners - either individual stocks or entire asset classes -- adds little to portfolio returns over the long term. Instead, history shows that asset mix is the key driver of total portfolio returns. Index funds can help you make better asset mix decisions because they provide the ability to invest in a distinct asset class. For example, when investors choose a Taiwan index fund traded on the Hong Kong Stock Exchange, they know exactly what they are investing in - Taiwanese stocks. But when they select an active Taiwan equity fund they may not know exactly what they're investing in. The active fund could have a bias to small cap stock, which are relatively illiquid, a tilt to or avoidance of certain sectors and/or a high allocation to cash -- all of which may confuse the asset mix decision.
A number of studies have shown that the typical active fund manager in most markets does not beat the index. Therefore, since index funds tend to have lower investment fees and transactions costs, index funds should outperform the average active manager after fees. Although index funds do not guarantee above average performance, they do offer competitive and consistent performance over the long term. It's this consistency of performance relative to the market, and the peace of mind that you won't be faced with unpleasant performance surprises, that make index funds attractive.
Ability to match potential and projected returns
Nowadays, many brokers, financial advisors, and financial web sites offer modeling tools to help you project retirement income needs and resources. These tools help you understand how current investment decisions will affect future retirement income. And they typically use index returns in their projections. These tools may be more useful if you are investing in index funds that allow you to achieve index returns consistently over time.
Increased foreign diversification
Many investors want to diversify their investments beyond their home country. However, very few investors know enough of individual stocks in foreign markets. Index funds that benchmarked against internationally recognized indices offer a relatively less risky and cost effective channel for overseas investing.
By Barclays Global Investors, the world's largest institutional fund manager and leading sponsor of exchange traded fund.