[The following is based on an article originally published on March 13, 2002.]

It's no secret that the Fool is a vigorous proponent of index investing. (However, it is a secret that many Fool HQ employees violate the "no thongs" dress code expressed in the employee handbook.) And why not promulgate the virtues of index investing? Most investors -- whether they prefer mutual funds or picking their own stocks -- would do well to have a portion of their money in an investment that attempts to match the performance of a broad-market index.

You've probably heard the argument: Index funds outperform two-thirds to three-fourths -- depending on the time frame and who you ask -- of "actively managed" funds, i.e., funds that pay a group of people to pick stocks. Since index funds do not have managers, index investing is also known as "passive investing" (which sounds like something Gandhi would do).

I don't like the term "passive investing." First of all, it sounds wimpy, like you're getting pushed around by all the other investors. It also has an air of laziness. (When was the last time an employee was promoted for passivity?)

But mostly, I don't like the term "passive investing" because it's inaccurate, at least when used to distinguish most index funds from "actively managed" funds. Why? Because most indexes are themselves actively managed.

Let's take a look at the S&P 500, which has come to be seen as representative of the whole market. After all, its combined market cap is about 75% of the total of all U.S. equities. But on the other hand, it comprises just 500 of the 9,000 publicly traded American companies. You'll find just large-cap stocks in the S&P 500 -- no mid caps, small caps, micro caps, or tooth caps. Someone has to decide which 500 make the cut.

That job falls to the members of the Standard and Poor's index committee, who meet about once a month to discuss which companies are worthy. The committee made 30 changes to the index in 2001 and 21 changes in 2002. Many changes are due to mergers or acquisitions. However, sometimes companies are removed due to what S&P calls "lack of representation" -- i.e., the companies ain't what they used to be. For example, Enron was removed because its executives are going to rot in jail (well, I hope).

So, why do mutual fund managers find it so hard to beat the index funds -- the funds essentially managed by the index committee? Let's start with the criteria S&P applies to companies considered for the index. All candidates must be:

  • Large: Companies should have a market cap of at least $3 billion, and are generally the biggest companies in their industries.

  • Domestic: This is a relatively recent rule, so some foreign companies had been allowed to remain. However, the lingering seven foreign companies were replaced last July.

  • Truly public: About half of the stock must be in public hands, not closely held by the company, management, or a meddlesome family.

  • Liquid: Shares of the company must be easily bought and sold.

  • Financially sound: Companies must be profitable and fiscally sound. The committee is interested in companies that will be around for a while so as to keep turnover low.

Big, American, solid -- that all sounds reasonable, perhaps even conservative (at least when it comes to stocks). With these criteria in mind, the committee makes it selections -- which is where the "active management" comes in.

Some have argued that the index is managed too actively, and that the committee doesn't always stick to its criteria. Such arguments were put forth by MSN MoneyCentral Managing Editor Jon Markman in "Passive Aggressive" and "The S&P Is a Mutual Fund -- and a Bad One at That." It's thought-provoking stuff. After all, the index committee did add some real stinkers to the index at the height of the bubble, and then summarily kicked them out just a couple of years -- and a few 80% drops -- later.

But it's not just the committee's selections that make an S&P 500 index fund compelling. There are other reasons that explain the strategy's long-term success:

  1. Low costs: The average non-index equity fund charges about 1.5% a year in management and administrative fees. The index committee, however, works for free... at least in terms of how much index funds pay them. Therefore, index funds can charge as little as 0.18% a year. Right off the bat, that puts non-index funds more than one percentage point behind.

  2. The "list effect": That's the term given by the chairman of the index committee, David Blitzer, for the extra attention the stocks in the index are given. If an investor or brokerage firm is looking to investigate an industry leader, the S&P 500 is a good starting point.

  3. Let your winners run: The index has very low turnover, about 3%-6% a year. That's nothing compared to the 80%-150% you'll find in a non-index mutual fund. The index doesn't engage in profit taking, nor does it rebalance because a single company or industry has grown too big (though such factors are considered when new companies are added). As a market-weighted index, the bigger a company becomes, the more influence it'll have on the performance of the index.

So, are there any lessons the average investor can learn from the management of the S&P 500, and indexing in general? Sure.

First of all, keep costs down. Secondly, you don't have to take enormous risks; stick to solid industry leaders and you'll probably do all right. Third, buying and holding winners does work, though there are times when you have to kick out the riffraff. (Also, active trading adds to your costs, not to mention your taxes). And finally, the term "passive investing" should be changed to "aggressive coattailing" or "judicious copycatting."

As for the question of how much of your assets should be in index funds, that's a question we'll be answering in our newest online seminar, Perfect Your Portfolio: Asset Allocation for Long-Term Wealth.

When it comes to thongs, Robert Brokamp turns the other cheek. When it comes to investing, he believes in "index plus a few." The Motley Fool is investors writing for investors.