July 8, 2007 by Matt McCracken

Index Investing is a strategy that consists of investing in passively-managed mutual funds and/or ETFs that are designed to mimic a particular index (i.e. S&P 500, NASDAQ 100, Russell 2000). Typically, index fund advisors use one of three fund families which are: Dimensional Fund Advisors (DFA Funds), Vanguard and Fidelity Spartan funds. (If you advisor recommends any other family for index funds, you’re likely paying too much.) Indexes were originally created by the Dow Jones Corporation around the turn of the 20th Century. They chose a sampling of stocks for the purpose of representing an entire sector of the stock market. The first index Dow Jones created was the Railroad company index, which no longer exists (a little factoid that is rarely discussed). The second was the Dow Jones Industrial index which still exists today but only one of the original stocks in the index is still included. At the heart of index investing is an academic theory created in the 1950’s by Harry Markowitz called Modern Portfolio Theory (MPT). MPT makes numerous assertions but most notably it says:

  • Capital markets are efficient meaning that no one person can beat or time the markets on a consistent basis and
  • Risk and return are positively correlated therefore taking additional risks will lead to higher returns.