Financial Literacy - Retirement income planning
Michael Buek
Why index funds beat active strategies

q_v2.gif What criteria does Standard & Poor's use to pick the companies that end up on the S&P 500 list?

a_v2.gifGenerally, index members must be U.S. companies that have a minimum market capitalization of $3 billion, and 50 percent of their shares must be available for purchase by investors. This is called public float. Corporate actions, such as mergers or acquisitions, can impact whether a stock is included or excluded from the index. Unlike many other indexes that are entirely "rules-based," the S&P 500 is maintained by a committee of eight members of Standard & Poor's staff that makes the ultimate determination of which companies are included or excluded from the index.

q_v2.gif At what point do companies get thrown off the index and why?

a_v2.gifGenerally, companies that are involved in mergers or acquisitions or significant restructuring may be removed, or those that shrink below $3 billion. Companies that don't have adequate liquidity or are financially unstable may be removed, or a company that moves overseas may be excluded.

q_v2.gif When Standard & Poor's announces a change in the index that is scheduled in the near future, do you begin buying the stock immediately? Or do you have to refrain until the date when the company is actually added to the index?

a_v2.gifThere is no requirement around how an index fund manages index changes. Our goal is to match the performance of the index as closely as possible and mitigate transaction costs.

q_v2.gif Do you actually own all 500 companies in the fund? If not, how many do you own, and what else do you own?

a_v2.gifYes, we own all 500. If an investor looks at our Web site,, they may see more than 500 listed under the portfolio holdings summary, but this is a technical issue. Some companies offer A shares and B shares, and when we buy them they are listed as two separate holdings, even though they represent the stock of a single company.

q_v2.gif Do you own S&P futures or options? If so, please explain in lay terms exactly what these contracts are.

a_v2.gifWe do own S&P futures contracts. Readers are probably familiar with futures from early-morning radio reports that monitor futures prices to indicate whether the markets will open higher or lower for the day. S&P 500 futures are a contract between a buyer and a seller to buy the stocks of the S&P 500 at a certain price, on a certain date in the future. Since the contract is a "promise" to buy the underlying stocks, only a small amount of collateral is required upfront, rather than the full dollar amount required to buy all 500 stocks. If the S&P 500 index moves higher or lower, the prices of S&P futures contracts move in lock step. Futures are very liquid, so mutual funds use futures to put incoming cash to work in the markets, and that cash will earn a similar rate of return as the stocks of the S&P 500. Likewise, to meet investor redemptions, it can be more efficient to sell futures than actual S&P 500 stocks.

q_v2.gif Why is the S&P weighted by market cap rather than having equal representation of each company?

a_v2.gifWe believe that market-cap weighted indexes are the "right" way to index. Indexes should reflect the market that they are intended to measure, whether it is large-cap, small-cap or some other market segment. The best index is the one that most accurately measures the performance of that market. The appropriate construction of indexes is therefore weighted according to what investors own, or, market capitalization. Simply put, market-cap-weighted indexes measure the returns investors, collectively, could potentially earn from the broad market or segment of the market.

q_v2.gif That means the biggest companies have the most influence over the index's performance, right?

a_v2.gifYes, but in a broadly diversified index, the overall influence of any one company is relatively small.

q_v2.gif Is that another factor that makes the S&P 500 so hard to beat?

a_v2.gifPerhaps, but again, the benchmark is tough to beat because the average active manager is his own worst enemy. High costs inherent in an active strategy represent a tremendous headwind to overcome.

q_v2.gif What's your philosophy of active vs. passive management? Do you personally own only passive index funds?

a_v2.gifYes, all of my investments are in Vanguard index funds. That said, many people don't realize that Vanguard's earliest funds were actively managed funds, and even today about half of our investors' assets are in actively managed funds. We believe that the ultimate decision isn't between index or active, it's between low-cost or high-cost. For most investors, index funds are an easy, low-cost way to get broadly diversified exposure and can serve as the core of an investment portfolio. But there can be some managers that outperform the benchmarks over time. Active funds can play a supporting role in a portfolio, if you can select a well-managed, low-cost active fund.

q_v2.gif Is there an investment strategy out there that you consider superior to indexing?

a_v2.gifI'm a bit biased, but no.

q_v2.gif What do you think about enhanced index funds?

a_v2.gifDespite their name, enhanced index funds aren't index funds at all. They're actively managed quantitative funds, and typically higher cost than plain-vanilla index funds. Index funds are designed to measure the returns that investors in aggregate receive in a particular market -- the returns of all investors in large companies, or all investors in China, for example. Enhanced index funds don't do that. Instead they take an index, and include or exclude stocks with specific characteristics or "factors," with the goal of beating an index like the S&P 500. There's nothing inherently wrong with this type of quantitative investing, and in fact, Vanguard runs several actively managed quant funds. But, we're all for truth in labeling.

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