Most professional fund managers measure performance relative to ‘The Index’: a collection of major stocks in the market concerned.  Each major market has its own index: the CAC in France, DAX in Germany.  Larger markets may have several.  The UK offers the FTSE 30 (broadly the largest 30 companies), FTSE100 (largest 100), and FTSE 250 (you have probably guessed it, broadly the largest 250).  The USA offers a choice: The Dow Jones Industrial Average (DJIA / Dow) of 30 large companies, Standard and Poor’s (S&P) index of 500 large companies, and the NASDAQ composite with a bias to the tech sector in the choice of its 100 constituents.  Japan has the TSE and TOPIX.  There is also the MCSI World Index that tracks stocks across all developed (but not emerging or frontier) stock markets.

The DAX is a ’total return’ index that assumes dividends are reinvested.  Most indexes do not .  Some are price weighted (in which case they tend to omit shares such as Berkshire Hathaway with its $300,000 per share price), many are ‘Capitalization weighted’ ie if Apple has a Trillion dollar capitalization (market value) and Exxon Mobil has a $333 Billion capitalization, then any (percentage) change in Apple’s value is three times as significant as a change in Exxon Mobil’s value - ie bigger companies count for more.

The key point is that most professionals fail to ‘beat the index’.  This has driven billions into unmanaged / passive funds that simply track an index, usually for a modest annual fee.  It used to be ¼% to ½% but competition has driven fees down to as low as 1/8 %

Index Funds Vs direct index ownership
For exposure to ‘the index’, buying an index fund is optimal for small to medium sized investments, if building a portfolio by making regular monthly investments, and when reinvesting dividends.  For the larger investor, taking a strategic long term position, buying the underlying equities may be a better option on 3 fronts

A) Lack of ongoing charges. Even if the index fund charges are low, for someone investing with a 10-40 year time horizon, the compound impact of the fees may not be entirely trivial.

B) Direct equity ownership gives you an, albeit small, amount of control. You can attend AGMs, vote on remuneration policies, etc. Index funds make you voiceless and tend not to vote at all.   If they do vote their shares, they may well make choices that are not in line with what you would choose. Note to enterprising index (and other) fund managers - you could use an application to let clients show how they would like their interests to be voted, and then act as their faithful proxy when voting.

C) The presence of a fund management house creates an extra layer of risk. If you own securities directly, you can have the share certificates in your physical possession (or in a bank deposit box). Or you can have ‘paperless’ certificates registered to your own name. With an index fund, it is the Fund that owns the underlying shares, and, because it makes trading simpler, they are likely to use the services of a custodian like State Street to hold their shares. This is fine and efficient while things are going well, but when your shares are registered in the name of a third party, there is always a risk that the third party will use the shares as collateral for their own speculations. This has happened before (though not with Index fund shares) and it will happen again. The risk is probably low, but it is not zero.

For all these reasons, those with significant assets may be best holding the underlying shares directly. But the threshold to qualify as ‘significant’ is quite high. For most of us, an index fund provides a lower cost of entry, and also allows fractional ‘units’ of the index to be acquired so the investment can be £100 or £1,000, or £100,000. Direct ownership requires a commitment to rather larger chunks.

At its simplest, if you are investing in the FTSE100 then direct equity ownership involves paying dealing fees to buy 100 securities. If you pay £15 per trade, that is £1,500. So you will need to be investing many hundreds of thousands of pounds, before this up front £1,500 is less significant than 1/8% annually on an ongoing basis. If the index you want to track is not the UK’s FTSE but the US Standard and Poor 500, or the Japanese Topix with c1,700 first section components, the ‘break even’ point is in the millions.

Dealing Fees aside, to track a capitalization weighted index perfectly you can’t just buy one share of each company. Doing that would give you a portfolio weighted by share price.. Berkshire Hathaway, ‘A’ shares trade at over $300,000 each, while the typical S&P500 share is under $100 (lets assume $50). 500x$50 = 50,000. So a share price weighted S&P500 including Berkshire Hathaway, ‘A’ shares would be 85% Berkshire Hathaway and 15% everything else. That might be a winning strategy, but it is not index tracking.  The ratio of ‘one share of each company’ also places your portfolio at risk of adjustment due to share splits / consolidations. Shares of Royal Bank of Scotland in the UK used to trade at c£2.50, but tumbled to 25p: management didn’t like having “penny shares’ so they consolidated the share base, replacing 10 old shares (by then trading for 25p each) with one new share (trading at £2.50), for a ‘I share of each company’ portfolio, such an event would increase exposure to RBS by 900%

To track the index closely, ie to have whole numbers of shares in each company correlating to the index weighting of the company, you would need to be investing tens of millions. A modest degree of ‘tracking error’ need not be a big problem, not least as discrepancies may be as likely to increase as to decrease returns, but it is fair to say that an index fund is probably easiest for smaller institutional investors as well as almost all retail investors,

An index fund also reduces the required attention / effort as it automatically re-balances when an index’s composition changes (from time to time incumbents whose capitalisations are shrinking are pushed out of the index by new companies entering: in 1990 Facebook, Amazon, Google, & Netflix did not exist, far less were they part of any index. Apple was only a niche computer maker loosing out to Microsoft.  In 2020 they are giants Facebook, Amazon, Apple, Netflox & Google account for almost 1/3rd of the NASDAQ index

The imperfections of holding an index via a fund are real, but, for most people, most of the time, are largely academic. It would be a mistake to allow these imperfections to prevent use of a fund (assuming that your objective is broad index ownership).

Caveat Indexor

Those composing the index do exercise a degree of discretionary control; inclusion is not automatic once a company becomes large, hence the delay in including Tesla in the S&P500 when it has a larger capitalization than many companies in the index.  I suspect that this helps index investors: a Tesla CEO who deliberately creates a false market in the company’s shares (by announcing that Saudi Arabia had agreed a funding deal when actually they had not) for the purpose of harming ‘short sellers’ (those betting the Tesla share price will fall) does not inspire confidence.  But such discretion gives immense power to those making the ‘do we include this share in the index’ choice.   If they say ‘Yes’, a company previously outside the index will get an immediate surge in demand for its shares, as Index funds rush to buy.  Human nature, and the history of finance, suggests that companies vying for inclusion in the index will devote considerable resources to ensure they get in.   Temptations will be put in the path of those making the choice, decisions will not be made by wise monks sitting at the top of a mountain, they will be made by ambitious people working in finance, with their own mortgages to pay and worldly imperfections.  Such fallibilities at the margin do nothing to undermine the general point that the index tends to outperform active management, but, as more and more money is placed in index funds, it helps to remember that the index is only a means to an end:  ‘Tracking error’ is OK,  going slightly off piste with some of your portfolio is OK.

A parting thought: the more money that goes into index funds, the greater will be the incentive for a ‘Bernie Madoff on Steroids’ scam in which a rogue entrepreneur creates a façade big enough to get their company’s shares into a major index.  The moment that happens, all the index funds HAVE to buy the shares, and, by issuing more shares, the company can virtually print its own money.  The Enron & WorldCom frauds were, at least in part, facilitated by the inclusion of their stocks in the S&P 500, though that inclusion was not the initial driving force of the frauds.  I rather suspect that we would already have seen an index-driven fraud strategy blow up, were it not for the fact that the ready access to cheap money is so valuable that, once the gates are unlocked, genuine profits are achievable.   On a much larger scale, it echoes the supermarket set up in the 1950s in east London.  Set up by local villains as a ‘Long Firm’ operation: the intention was to build up credit lines, and then disappear one night, with a few months takings, leaving the suppliers, landlord, and tax man, unpaid.   But, in the course of building up trade so the eventual haul would be large enough to fund a decade or two on a Spanish beach, the villains found that they were making so much money legitimately, that there was no point in disappearing: the ‘Long Firm’ had gone straight, though only by accident.


Will you lose money tracking the Index?

If you are investing for the long term, the odds are against losing money by index tracking, though it is possible: If you owned the Nikkei 225 in the late 1980s, when it was c39,000, you would still be nursing a big loss 30 years later.  But you might have been even worse off had you invested in an actively managed Japanese fund focused on growth stocks.  Index tracking can be a sensible ‘Plan C’, if you don’t have the time to run your money yourself, and have not identified an active manager that inspires trust & confidence.  Unfortunately, finding such an active manager is seldom easy  

A Final shot

Be aware that you are not the only person who may be thinking about trading around an index: buying good companies that are just outside the index, or are in countries classed as ‘Frontier markets’ and thus outside the World Indexes.  Such ‘just not included’ stocks may have the advantage of usually being a bit cheaper than equivalent quality within the/a index: when there are trillions of dollars devoted to index tracking, the stocks in an index will have their prices bid up by the index trackers: if the index is the top 500 stocks, then stocks 501, 502 and 503, are unlikely to be noticeably inferior to stocks 498, 499, and 500, but may be noticeably cheaper.  And, those holding stocks 501, 502 and 503 may see values jump if any of them are eventually admitted into the index & thus bought by index trackers.  There are three main ways that stock 501 can get ‘promoted’ into the index, and two of them don’t even need company 501 to do anything spectacular.  One way is, of course, for company 501 to achieve amazing growth & for the stock price to rise high enough that it achieves a higher capitalization than company 500 (the process of re-constituting the index is not instant or automatic, but this is likely).  But, just by treading water, company 501 could be promoted if two of the top 500 index members merge (as happened in the UK when Lloyds bank made its disastrous acquisition of TSB), or if one of the 500 ‘blows up’ as Lehman brothers did in 2008 due to trading losses, or  as Hoover did when its marketing team offered customers free flights with each new washing machine, and the flights were more valuable than the washing machines (this was a rare case of ‘if it seems to be too good to be true, it probably is’ not applying: the offer really was too good to be sensible or sustainable, but Hoover honoured the offer, thereby ruining itself).