How Did Indices Change the Fund Management Business?
After indices were developed, investors used them to measure how an investment manager performed compared to the overall market measured by a benchmark such as Standard & Poor's 500 Index, which tracks the performance of 500 of the largest companies listed on U.S. stock exchanges.7
In the 1960s, numerous academic studies showed that most investment managers on average failed to outperform the major market indices such as the S&P 500—even before subtracting the fund's expenses from the returns.8 Factoring in fees made it clear that active mutual fund managers benefited themselves at the expense of investors. Investors would have done better in most cases if they could have just invested in an index. The problem was they couldn't.
However, the birth of the index fund in the 1970s changed all that. The index fund tracks the performance of a market index by holding the same securities that make up the index in the same weights as the index.9 That way the fund's performance matches the index, aside from minor variations due to the fact that an index incurs no costs, as opposed to a fund.10 Pension funds and other institutional investors first used indexing. Retail investors then got into the game with the launch of the Vanguard 500 index fund, the first retail fund to track the S&P 500. This proved a cheaper way to invest, because these funds did not require investment managers and research departments—the index did the work for the fund—the fund company simply had to adjust its portfolio to match the index, as opposed to research and buy securities.
The birth of index funds spawned a new business—index manufacturing—that created new indices to benchmark managers in all areas. There are indices based on market capitalization, investing style (value or growth), sectors (such as biotech, green, and infrastructure), and all sorts of other categories. New funds, especially ETFs, have emerged to track these indices.