Index Funds

An index fund tries to emulate the movement of an index. A commonly used Swedish index is the OMXS30 index which include the 30 most traded shares on the Stockholm Stock Exchange. The index is value weighted which means that giants such as HM, Nordea and Ericsson's price movement will affect the index more than the price movements of companies such as Eniro and Swedish Match. The idea behind an index fund is not to chase the hottest shares, but to hold a broad basket of shares with minimal costs.

The cost makes all the difference: Annual transaction costs can sum to several percent for ordinary funds that trade actively and hence are called active funds. Index funds, also known as passive funds, are so called because they passively own the shares that are included in the index that they follow.

Another major cost to a fund is the management fee. If you visit Morningstar you can see that the management fee usually amounts to 1.5% per year for the average Swedish Equity fund. For Xacts most common index funds (Xact OMX S30 and Xact OMX SB) the management fee is 0.3%, only one-fifth of the cost of ordinary funds.

A common argument against index funds is that they only return the stock market on average, and that, one therefore should invest with a manager that can beat the index. If this was the case, this would justify the higher fee and higher transaction costs. This is the active managers favourite argument. Obviously, they are right. The only problem is that it is very difficult to identify an active fund that consistently beats the index after expenses.

As the Business professor Harry Flam writes in the biggest Swedish daily, DN (Letters to the editor 30 / 5 2007): "Comprehensive empirical research shows quite clearly that professional asset managers are performing below the market average after deducting the added cost of active management."

"On the stock market usually only 25-30 percent of the funds surpass their index a given year and only around ten percent will manage over a twenty year period." He goes on to state that "Such a [passive management] style tend to give the same level of return as that of active management. It certainly reduces the management costs."

Since the returns of an index is a weighted average of the stock market returns an active investor must make a loss for another to make a profit. It is interesting to note that roughly 80% of car drivers believe themselves to be better than average.

An index investor does not participate in these transactions, and thus receives an average of the market's safe return. All active funds will also have transaction costs, which index funds minimise or avoid altogether.

William Sharpe, who received the Nobel Prize in economics in 1990, writes that "Properly measured, the average actively managed dollar must return less than the average passively managed dollar, after expenses. Empirical studies that seem to run against this principle are not properly measured. " The legendary investor Warren Buffett writes in his letter to shareholders in Berkshire Hathaway (1996) "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

By investing in index funds, you can make sure that you receive as large a share of the proceeds as possible.

At DN.se you can read Harry Flams views in letters to the editor: http://www.dn.se/DNet/jsp/polopoly.jsp?a=655542

Read William Sharpe's article: http://www.stanford.edu/~wfsharpe/art/active/active.htm