Back to school: breaking down an index fund

It's time to buckle down and get serious. Kids are back at school; we adults need to focus on the basics.

First, some homework. Let's deconstruct an index fund, and look at why this investment instrument works. You need to read this new article that we wrote and diagrammed. It explains the under-the-hood mechanics:

Some observations are in order.

1. Notice that the index has a "spread your bets" approach. It is acting like a large venture capitalist. Years ago venture capitalists learned the advantage of size. No matter how much they study a firm or industry, random probability plays a part in whether they hit a big winner. Because the upside of a win is so large, it makes sense to gain exposure to many bets.

This is what the index is doing on a less extreme scale. Despite the fact that most stocks turn out to be at best yawners and at worse worthless, the index is searching for exposure to the big winners to offset everything else. It searches by diversifying widely.

2. Good index investors watch fund construction for tax reasons. The index fund industry is getting better here in general, and they were already good. Under the hood of the index fund, managers are swapping positions to minimize tax exposure. You can read about one of these techniques, called heartbeat trades, here.

3. Indexes create good investment behavior. This year, indexes have been pushed out of the news by stock trading hype. That's fine. Look, if you're locked in your college dorm room and you already dominate the record board on Grand Theft Auto, maybe trading some stocks on an app is a good idea. The market went on a tear over the past year, and because you're probably not controlling for baseline performance or worrying about all those capital gains tax bills your trading will create in April, you feel pretty smart. But what you have done is taught yourself some very bad habits. On the other hand, indexing builds habits of patience, humility toward the market, tax awareness, and reduced financial media consumption.

4. Stick with market-cap weighted index funds. On the equity side we generally use index funds that reflect the market capitalization of their underlying stocks. There are lots of other flavors, such as index funds that weight based on profitability of the underlying firms. You might think "Well, that makes sense, if the firm is more profitable it should get a higher weighting." But that's only one variable in an enormously complex equation that millions of people around the world work on every day, and the market capitalization is the final reflection of their collective opinions. Feeding the market capitalization into the index captures the broadest scope of known information.

Dan Cunningham

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