Overview

The best way to invest in stocks is to invest in index funds. Index funds are truly low-cost products that are advantageous for investors – Warren Buffett

Index funds are mutual funds that strictly adhere to a specific composition regardless of market conditions.

These are passive funds aimed at replicating specific indices like the S&P 500, meaning fund managers cannot actively choose which securities to buy as they can in active funds. Index funds operate by purchasing the stocks that make up the index in the same proportions as they are represented in the index. This approach aims to achieve returns that match the average market returns, making index funds the quintessential example of passive funds.

Predicting whether individual stock prices will rise or fall is difficult, and frequent trading incurs high transaction costs that reduce fund returns. Therefore, the idea behind index funds is to pursue the market’s average return with minimal management fees, thereby enhancing fund returns.

Index funds have become a benchmark to beat for many other funds due to their higher returns compared to most other funds. When evaluating the performance of investment professionals, the returns of index funds are often used as a standard. In the 2022 investment competition, the majority of participants failed to surpass the returns of index funds.

History

The first index fund was established in 1971 by Wells Fargo Bank. However, the popularization of index funds began with John Bogle, known as the father of index funds, who launched the “Vanguard 500 Index Fund” on December 31, 1975. When John Bogle started this fund, it was met with skepticism about its viability as a stock investment, but it gradually gained popularity and eventually surpassed the “Magellan Fund,” a prominent active fund, in net asset value in 2000.

Based on the Efficient Market Hypothesis, index funds generally yield higher returns over the long term compared to other funds. Pension funds, which are enormous in scale and have high management fees, typically rely on expert advice to choose top fund managers. However, over 90% of the 243 pension funds managed between 1987 and 1999 underperformed the market. The revelation that over 90% of star fund managers could not exceed market returns was shocking, leading to over 80% of most pension fund portfolios now being composed of index funds. The world’s largest index provider, S&P, publishes annual SPIVA statistics, demonstrating that it is very challenging for active fund returns to surpass those of index funds. While stock index funds are riskier than bonds, they are considered conservative in the realm of stock investments. Nowadays, to reduce management fees and facilitate easy redemption, index funds are being increasingly securitized into ETFs, solidifying their dominance in the market.

Structure

Index fund portfolios are filled according to the market capitalization proportions of the index components. Thus, with enough skill, one could theoretically construct a portfolio that mimics an index fund without actually investing in one, a method known as full replication. However, with indices like the KOSPI comprising over 700 stocks, full replication is challenging. Instead, partial replication is used, where only about 80-90 of the top market capitalization stocks are replicated. Additionally, to exceed market returns, weaker fundamental stocks among the top stocks are often excluded. Since the movements of the KOSPI index closely mirror those of the KOSPI 200 index, many KOSPI index funds track the KOSPI 200. The KOSDAQ index, after various adjustments, achieved a correlation coefficient of 0.964 with the KOSDAQ 150, exceeding the 0.95 standard for replication indices, leading to the unification of various funds and products around the KOSDAQ 150.

Leveraged Index Funds

These funds aim for higher returns by combining derivatives with index tracking. For example, a KOSPI 200 2x leveraged index fund would achieve returns twice the movement of the KOSPI 200 index. Hence, the returns double both when the index rises and falls.

Inverse Index Funds

These derivative products move in the opposite direction of the tracked index. If the index rises, the fund incurs losses, and if the index falls, the fund gains. They are suitable for investors expecting a decline in the stock index and offer a convenient alternative to short selling or put options for betting on index declines.