Like many index fund users, I have done my share of complaining about the undesirable features of equity benchmark indexes adapted to index fund applications. I find the opportunity to address the construction of a "perfect" index for an equity index fund very welcome.
Most of the principles of fund-friendly indexes apply equally to conventional mutual funds and to exchange-traded funds (ETFs), but I focus on indexes for ETFs. The exchange-traded fund is almost certainly the index fund structure for the 21st Century. Not only is the ETF more tax-efficient than a conventional mutual fund, making it an inevitable choice for any intermediate or long-term taxable investor, it also offers lower expenses and an opportunity for systematically superior returns relative to a conventional mutual fund.
Of course, creating just one perfect equity fund index is not enough, because investors demand a variety of index funds. A few indexing purists may argue for the use of a single, very broad index of U.S. stocks such as the Wilshire 5000 and a single broad-market index of foreign stocks to provide appropriate international diversification, but such basic index funds do not meet all investors' needs.
A broad-market foreign equity index, particularly if it is implemented in the form of an exchange-traded fund (ETF), will not create a very good fund. Security clearance, settlement and custody procedures outside the United States are at a relatively early stage of development. The National Securities Clearing Corp. (NSCC) and the Depository Trust Co. (DTC) have done such a good job in the United States that they have created unrealistic near-term expectations for securities operations in other markets. Any ETF that relies on in-kind creation and redemption involving the diverse clearance, settlement and custody systems used in world markets will face extraordinary costs if it covers all major foreign markets. For the most part, these costs will fall outside the fund's expense ratio, but they will be very real costs to the investors who trade and hold the fund. The high transaction costs associated with creation and redemption in a multinational fund assure a wide bid/asked spread in the ETF share price. Transaction costs inside the fund will also be relatively high.
In the U.S. market, there are many reasons why investors might want to own more than a single index fund, even if the expenses for a single broad-based index fund are quite low. Most investors with significant accumulated wealth have their most valuable assets in undiversified positions which, for lack of a better term, I will call their "primary holdings." Whether the wealth represented by primary holdings comes from an inheritance, from the development of a business or from stock ownership accumulated during a career with a single employer, it is often difficult or impossible to achieve adequate diversification by using only broadly diversified index funds to supplement these concentrated positions. Investors often compensate for lack of diversification in their primary holdings with special-purpose funds that provide exposure to sectors or investment styles not represented in their primary holdings and offer a few tax reduction opportunities as well.