What is an index fund?

What is an index fund?

There's a common misconception that index funds are run entirely by computer, quietly ticking along with no human involvement. In reality, the indices they track are overseen by a committee of experienced financial professionals who make careful, considered decisions about what goes in and what comes out. Understanding how that works reveals a great deal about why index investing is so effective.

In this video, David Blitzer, Chairman of the Index Committee at S&P Dow Jones Indices, explains what an index fund is and how the committee decides which stocks to include. Crucially, the committee's objective is very different from that of a portfolio manager. A portfolio manager wants to make money and achieve high returns, which is perfectly fair. But the index committee's job is to ensure the index accurately reflects the market it's designed to measure. In the case of the S&P 500, that means faithfully representing the US large-cap market, so including stocks that are too small, or that don't fit the index's stated objective, would mean failing at that task.

You'll learn that far from picking stocks at random, the committee follows strict, clear criteria. To join the S&P 500, a company must be US-based, profitable under generally accepted accounting principles (GAAP) over the last four quarters combined and the most recent quarter, sufficiently liquid, and reasonably large in terms of market capitalisation. These rules ensure the index genuinely reflects the market rather than the whims of any individual.

You'll also learn that an index is far from set in stone. It has to be constantly monitored and maintained, with roughly 15 to 20 changes a year as new stocks enter and others make way. Blitzer, who chaired the committee for more than two decades, explains how a group of professionals debating each decision, each bringing their own perspective on what's happening in the market, produces an index that reflects the market as a whole remarkably well. And tellingly, when you look at the results, most so-called active managers more often than not fail to do as well.

Chapters / Key points

• Why the "index funds are run by computer" idea is a myth
• What an index committee's objective actually is
• How that objective differs from a portfolio manager's
• Why an index must faithfully reflect its target market
• The strict criteria for joining the S&P 500
• Why profitability, liquidity and size all matter
• How often the index changes each year
• Why a committee of professionals does the job so well
• Why most active managers still fail to beat the index

Transcript

What is an index fund?

Robin Powell: A common misconception about index funds is that they're run by computer. In fact, they're managed by a committee of experienced financial professionals.

David Blitzer is Chairman of the Index Committee at S&P Dow Jones Indices. I started by asking him, what is the committee's objective?

David Blitzer: The objective of the committee is very different from the objective of a money manager or a portfolio manager. A portfolio manager wants to make money, he wants high returns, and that's perfectly reasonable and very fair. But the index committee is interested in making sure the index reflects the market and is a proper measure of the market. And, if the index has a particular objective, in the case of the 500 it's the US large-cap market, it should do that. If we had stocks in the 500 that were much too small, we wouldn't be doing our job, we would not be reflecting the US large-cap market. If we had an index that's designed to choose stocks that pay high dividends, and that's very popular in the last several years, you want to make sure the stocks do pay high dividends, otherwise they don't belong in there.

Robin Powell: So, how does an index committee decide which stocks go into a particular index? Well, it has to abide by very strict criteria.

David Blitzer: You shouldn't get the idea that we're sort of flipping coins and throwing darts or anything like that. First, there are clear criteria for including a stock in the S&P 500. It has to be a US company, it has to be profitable, based on GAAP, generally accepted accounting principles, over the last four quarters summed together, and the most recent quarter. Nobody wants to buy companies that lose money. The stock has to be liquid, and to be in the 500 it has to be reasonably large, about $6.5 billion or more in market capitalisation.

Robin Powell: Far from being set in stone, an index has to be constantly monitored and maintained. Somewhere around 15 to 20 times a year, a new stock will enter the index and another one will make way for it.

David Blitzer: What I've seen, because I've sat on the committee and actually chaired it for over two decades, is that the ability to choose the stock and debate it among a group of professionals who talk about it and see what's happening in the market, each one bringing his own perspective on what's going on, really does a very good job of having an index that reflects the market overall and what's going on in the market. Looking at the investment results, it turns out, more often than not, most so-called active managers don't do as well.

Robin Powell: That's it. Thank you to David Blitzer from S&P Dow Jones Indices, and to you for watching.