By Joshua Kennon, updated September 19, 2018
Excerpts below; read the article here
Methodology of the Major Index Funds
Buying an index fund is in a way outsourcing your thinking to someone else. In the case of the Dow Jones Industrial Average, it is the editorial board of The Wall Street Journal, which determines the components in the world’s most famous stock market index. In the case of the S&P 500, it’s other investors who set the prices of common stocks by buying or selling them directly, determining the market capitalization of each firm. Both still involve human judgment, just not yours.
What makes this somewhat untenable to sophisticated investors is that index funds ranked by market capitalization (for example, the S&P 500) are structured in a way that means you buy more shares of a certain stock as the price gets more expensive, and sell shares as it gets less expensive—buying high and selling low.
Unfortunately, it’s the only feasible mechanism because the assets invested in index funds are so massive it makes fundamental or equal weightings impossible to achieve. Vanguard or another large index fund could not have an S&P 500 equally weighted index fund with their current asset bases. A sophisticated investor could construct one directly, though.
Reasons to Use an Index Fund
A sophisticated investor might want to not worry about her family after he/she has died. Warren Buffett himself has said that upon his passing, his wife will be left with the bulk of her fortune invested 90 percent in S&P 500 index funds and 10 percent cash despite the fact that he has never personally owned a mutual fund.
Index Fund and Taxes
Imagine you wanted to mimic the S&P 500 or Dow Jones Industrial Averages. Instead of buying a mutual fund run on an index mandate, an investor with a decent-sized portfolio could just as easily build the index directly themselves by purchasing the underlying shares of stock that make up the index. This would allow advanced tax harvesting techniques, keeping more money in your pocket when the IRS bills are due. John Bogle explains this in his books on indexing, writing, “Holding individual stocks for the long term may not only be wise but be far more tax-efficient.”