Index Funds and ETFs are used to provide investment performance that matches a well-known benchmark, such as the S&P 500 or the Dow Jones Industrial Index. Indexed Investing is the only equity investment strategy with decades of performance-related statistics available. Since 1927, the Index has a CAGR of +10.27% over an 80-year history.

Popularized by John Bogle and based upon academic work by Eugene Fama, Indexing was originally derided as "un-American" because the perception was that investors should settle for average rather than exceptional performance.

However, Indexing offers superior and more consistent returns than most actively managed funds. For example, Bogle's Vangard S&P 500 fund has beaten the performance of over 90% of other mutual funds over the last ten years.

Most of the superior performance of Index tracking funds is due to stock selection, but lower turnover costs and management expenses are also factors.

Later work by Fama & French led to the creation of other indexes weighted by market cap and book value. Investors now usually hold multiple indexes to improve diversification. For example, small-cap value stocks have returned +13.3% annually over 80 years but have higher volatility.

Indexing is firmly established in the investing marketplace. Over $1 trillion is currently indexed, and there are estimates that one-third of all new money flowing into common-stock money market funds is invested in some type of index fund.

There are many index-driven ETFs to choose from that are publicly traded and that also provide high investment returns, such as the SPY (S&P 500), MDY (S&P Midcap), IWM (S&P Smallcap), and EFA (MSCI Europe & Far East).

ETFs are the core of many retirement portfolios and are considered ideal for long-term investors because when combined into diversified portfolios, they provide high performance, liquidity, and relatively low volatility. As investments, they also require no monitoring, aside from periodic rebalancing.

Indexing works because of market efficiency. The concept of Market Efficiency is based upon work by Eugene Fama in 1970. Fama’s thesis is that, at any given time, market prices fully reflect all available information on a particular stock.

EMH states that individual investors who try to beat the market are actually contributing to the market's efficiency. They find pricing anomalies in the market and their buying and selling actions move the prices towards the level that results in the investment providing a reasonable, risk-adjusted investment return.

Some people dismiss EMH by pointing to market situations in which a stock was clearly overvalued or undervalued. However, market efficiency is not a yes or no question. If most of the stocks, most of the time, are near their fair value prices, then the market is reasonably efficient.

Many indexers, such as Vanguard’s Bogle, use EMH to imply that active investing will never deliver superior returns to indexing. We think that’s a bridge too far. A market that’s efficient enough for indexing to work well could still be inefficient enough for some investors to benefit from pricing anomalies.

An opportunity to borrow at a lower rate and invest at a higher rate is an opportunity to convert short-term cashflow into long-term asset appreciation.

Investing using debt, also known as leveraged investing or the carry trade, is risky in the short-term. This is because fluctuations in the market value of the asset as compared to the level of debt will create large percentage changes in the investor's equity.

In the long-term, however, the investment compounds at a faster and faster rate. If the investment returns are relatively predictable, the long-term result is also predictable, even given a high level of leverage.

This means that investors with leveraged investments need to ensure that they have a long-term investment horizon, and that they have the financial resources to handle the expected interest payments needed to support the larger investment.

The Three Commandments for Leveraged Investing:
1) Money can be borrowed cheaply compared to expected long-term appreciation.
2) The investor has a long-term horizon and will not be forced to sell the investment prematurely in a down market.
3) The interest payments are affordable and the investor is not relying on future capital gains to make interest payments.

This is the heart of the leveraged indexing strategy. What will a leveraged index investment do over fifteen years? The first tab is standard 10% growth, the second tab is random returns. This model has some annotation.

http://www.indexroll.com/15-year-model.xls

In 20 years, a leveraged index investment might be worth 50x its original value, or it might be worth nothing. We run 1000 4x leveraged investments for 20 years and see what happens. The first sheet gives averages and standard deviations. Our investment doubles every 5 years, on average. Copy the results from the first sheet to the second sheet and sort them to find out the percentile rankings.

http://www.indexroll.com/20-year-leverage.xls

The index may be more volatile than you think. Here are the 30-day, 60-day, 90-day, 120-day, 180-day, 360-day, and 720-day returns for SPY from 1993 to 2007. Then we do a little more analysis on the 30-day returns to find the "fat tails". For 35% of the months observed, the index was down, and for 7.6% of the months, it was down more than 5%.

http://www.indexroll.com/index-analysis.xls

Simple chart that calculates the average return and standard deviation of the SPY index over a one to seven year holding period and makes two standard deviation wide bands. For example, the index held for 7 years will return +95% with a 40% standard deviation, meaning your returns will be somewhere between +15% and +174%. That's a wide range.

http://www.indexroll.com/stdev-calc.xls

This is a model that backtests a dollar cost averaging reinvestment strategy from 1993 to 2007. We purchase 6000 shares of SPY at a very high level of leverage and then buy $100 worth of shares every month using debt. The fund returns $18.26 for every $1 invested in 1993, as compared to $4.06 for the index.

http://www.indexroll.com/leveraged-index-test.xls

This is some neat research. Using leverage allows you to actually remove a source of volatility from your returns - the volatility caused by having varying amounts of capital invested every month. Here we test two strategies - one in which the amount of debt is constant over the life of the investment, and one where the amount invested is constant and the debt varies. Its a random model so you have to run it a few times to see the conclusions - that fixed investment strategies have lower volatility.

http://www.indexroll.com/fixed-investment.xls

1) Why do the indexes return 10%? And why would someone loan you money for 4% to invest at 10%?

2) Are you sure that the indexes will keep going up? What about oil prices, terrorism, the baby boomers, the trade deficit, bird flu, etc?

3) What about the internet bubble? The markets were terrible from 2000 on. Why would I want to borrow money to invest in those kinds of markets?