An index fund is a type of fund which tracks the components of a financial market index of a certain stock market or asset class. That is where the name index fund comes from.
Investing in an index fund which follows a certain stock market is like investing in a basket of the assets of the corresponding stock market of said index. If we invest in an index fund such as STOXX 600, it is as if we were investing in the most important European companies listed on the European stock exchanges, which are all included in the STOXX 600.
That is why, just as with any investment fund, it is an excellent financial instrument to enjoy great diversification with a smaller investment.
An index fund follows a type of management known as passive management. Passive management is the opposite to active management.
Saying which type of management is best is complicated, as it depends on a lot of factors and is a highly contentious issue within the asset management industry. There are followers and detractors for every type of management, B. In any case, depending on the size and number of market participants, the time horizon of the investment, the type of assets, the quality of the asset managers, and how each investor assumes the risks over the course of the investment, one type of management may be preferred over another. Below we will address what scenarios and fundamentals are behind each type of management.
Additionally, in the case of index funds, there is no management when selecting assets, as they aim to track the behaviour of a certain index. There are several ways to replicate said behaviour, which due to how extensive they can be we will not go into in this article.
However, did you know that when we invest in the financial markets through an index fund we are implicitly assuming certain scenarios regarding their behaviour?
When we invest in an index fund we are foregoing what an active management fund would do. We are foregoing any extra returns which we may theoretically get by selecting better assets and better analysing the markets to see the best time to invest. We are implicitly assuming that it is not worth us managing the portfolio because we may not be able to achieve those extra returns or said returns are not enough to compensate for the analysis and transactional costs that this would involve.
By foregoing this it means that we consider the financial markets to be efficient enough.
A market is considered to be efficient when the price of a financial asset on this stock market is an unbiased sample of all of the opinions about its true value. The consensus of the whole market on said asset’s value is what fixes the price. For a market to be efficient there needs to be no asymmetric information and all of the information available must be quickly incorporated into the price of the financial assets.
When an analyst looks for investment opportunities, they implicitly assume that there is asymmetry in the information, that the information is not incorporated quick enough into the market, or that there are better market analysis models meaning that the market is not efficient enough to set the corresponding price for the true value. Strangely enough, the more analysts who believe that the market is not efficient, the more efficient it tends to be.
The Nobel Prize Winner Eugene Fama in his 1970 book “Efficient Capital Markets: A Review of Theory and Empirical Work”, came up with the theory “Efficient Markets Hypothesis (EMH)”. Fama presented the basic idea that the stock markets were efficient enough to make it almost impossible “to beat the market” on a systematic scale, meaning, obtaining investment returns that, in total, surpass those of the market.
Additionally, around 1965, Fama and other authors such as Cootner, Markiel, Kendall, and French, underpinned the theory that share prices move randomly, and therefore could not be predicted.
Both in the academic and industrial worlds there are a lot of different opinions on which type of management works better, especially in regard to market environment, asset class, and which markets.
What can be said is that for several decades, and especially over the last few years, indexed (passive) management through Investment Funds, and especially through ETFs, have gained prominence.
The management costs and the simplicity to implement investment strategies mean that index funds are becoming more widely accepted among investors. Robodvisors (robotic advisors) use these types of funds to build portfolios.
Beyond the debate of which type of management is best, it is undeniable that diversification is what improves the quality of our investments and that is why investing in different asset management types, also means diversifying our investments.
There are a wide range of Index Fund categories at www.morningstar.es – www.morningstar.com, as well as ETFs at www.justetf.com – https-www.etf.com, all based on the asset class or market you want to follow. There are also investment instruments which, through just one product, allow you to track all of the world’s assets (shares, company bonds, government bonds) in the proportion to the market composition at that time. Market Portfolio Asset Management (marketportfolioam.com).
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