How passively managed are index funds?
June 12, 2007Thanks for visiting! If you like what you're reading, you may want to subscribe to my RSS feed.
When I went home to visit my parents last weekend, I had the chance to chat to their financial advisor about investing and personal finance in general. And he made a very good point that I hadn’t considered before.
He claimed that many passively managed funds (i.e. index funds) aren’t necessarily as passively managed as we would like to believe and that this situation would become even more obvious if everyone suddenly decided to “do what they’re told” and invest all their money in index funds…
Why is that? Let’s think about this for a minute. What is an index fund? A fund manager trying to copy a stock index’s performance as closely as possible by buying similar or even exactly the same securities that are represented in the index. But the index itself is a benchmark instrument put together by companies… FTSE, S&P or NASDAQ are all companies specialising in compiling various stock market indices.
So what happens if everyone ditches actively managed mutual funds in favour of so-called index funds? The answer seems simple if you think about it. What effectively happens is that the money-making business now resides with index companies instead of fund managers. And as a consequence more indices get compiled which fund managers can then passively follow. But the index itself remains actively managed and therefore the whole point of index funds evaporates.
Do you agree?
