Legend has it, a pharmacist named John Pemberton was searching for a headache cure when he tried blending coca leaves with cola nuts. Who knew his recipe was destined to become such a smashing success, even if Coca-Cola® never did become the medicine Pemberton had in mind?

In a similar vein, when Charles Dow launched the Dow Jones Industrial Average (the Dow), his aim was to better assess stock prices and market trends, hoping to determine when the market’s tides had turned by measuring the equivalent of its incoming and outgoing “waves.” He chose industrials (mostly railroads) because, as he proposed in 1882, “The industrial market is destined to be the great speculative market of the United States.”

While the actively-minded Dow never did achieve market-timing clairvoyance (and neither has anyone else we’re aware of), he did devise the world’s first index. We would like to think his creation turned into something even greater than what he had intended; especially since Vanguard founder John Bogle and other pioneers leveraged Dow’s early work to create a more efficient way to invest in today’s markets: the index fund.

Bogle launched the first publicly available index fund in 1976. Initially dismissed by many as “Bogle’s folly,” its modern-day rendition, the Vanguard 500 Index Fund, remains among the most familiar funds of any type.

Index investing is born

In defense of Dow’s quest to forecast market movements, it is worth remembering that his was a world in which electronic ticker tape was the latest technology, there were no open-ended mutual funds or fee-only financial advisors, and safeguards and regulations were few and far between. Essentially, speculating was the only way one could invest in late-nineteenth century markets.

Compared to actively-managed solutions, index funds lend themselves well to helping investors diversify, cut costs, and minimize taxes.

Index investing: Room for improvement

One of the problems with index investing is that indexes were not specifically devised to be invested in. There is often a lot going on underneath their seemingly simple structures that can lead to inefficiencies by those trying to overlay their investment products on top of popular indexes.

  • Index dependence – Whenever an index “reconstitutes” by changing the underlying stocks it is following, any fund tracking that index must change its holdings as well – and relatively quickly if it is to remain true to its stated goals. In a classic display of supply-and-demand pricing, this can generate a “buy high, sell low” environment as index fund managers hurry to sell stocks that have been removed from the index and buy stocks that have been added.
  • Compromised composition – Asset allocation is based on the premise that particular market asset classes exhibit particular risk and return characteristics over time. That is why your investment “pie” should be carefully managed to include the right asset class “slices” for your financial goals and risk tolerances. If you are invested in an index fund and you are not sure what its underlying index is precisely tracking, you may end up with off-sized pieces of pie.

Introducing “rules-based” investing

So, yes, index investing has its advantages, but it also has inherent challenges. No wonder academically-minded innovators from around the globe soon sought to improve on index investing’s best traits and minimize its weaknesses. In fact, many of these thought leaders were the same early adopters who introduced index fund investing to begin with. Building on index investing, they devised rules-based investment funds, to offer several more advantages:

  • Index-independence – Instead of tracking an index that tracks an asset class, why not just directly capture the asset class itself as effectively as possible? Rules-based fund managers have freed themselves from tracking popular indexes by establishing their own parameters for cost-effectively investing in most of the securities within the asset classes being targeted. This reduces the need to place unnecessary rebalancing trades at inopportune times simply to track an index.
  • Improved concentration – Untethering themselves from popular indexes also enables rules-based fund managers to more aggressively pursue targeted risk factors; for example, a rules-based small-cap value fund often has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund.
  • Focusing on innovative evidence – Rules-based investing shifts the emphasis from tracking an index to continually improving our understanding of the market factors that contribute to the returns we are seeking. By building portfolios using fund managers who apply this same evidence to their funds, you can make best use of existing academic insights, while efficiently incorporating credible new ones as they emerge.

“passively-managed index funds offer a more solid solution for sensibly capturing available market returns.”

Indexing, revisited

It is important to remember that indexes do not help forecast what will happen next in the markets, nor do high-water index values such as “Dow 20,000” foretell whether it’s a good or bad time to buy, hold, or sell your own market holdings. And, while low-cost, well-managed index funds may still play a role in your overall investment portfolio, you should ensure that you are selecting them because they are the best fit for your rules-based investment strategy, not simply because they are a popular choice at the time.