When most people learn how to invest, the term "index fund" comes up frequently. Index funds can be great investments for certain types of investors, especially those that are just starting out.
In this post, we are going to explain how index funds work and why they may be great investments for some investors and might be totally irrelevant for others.
An index fund is a Mutual Fund or Exchange Traded Fund (ETF) that holds a group of stocks, bonds or other asset classes. An index fund is tied directly to a market index. Index funds are common investment vehicles because of their simplicity and diversification benefits.
Due to the simplicity of index funds, there are lower fees compared to traditional investment strategies. These lower fees are passed on to index fund investors.
A market index is a weighted index of a group of assets that may have similar characteristics, such as in the same sector, asset class, geography or market capitalization. There are hundreds of market indexes. A few examples include the S&P 500, Dow Jones Industrial Average and the Barclays Aggregate Bond Index.
The S&P 500 is a market cap weighted index, meaning it weighs each holding based on the market capitalization of each underlying holding. The S&P 500 is considered a large-cap index, holding the top 500 largest companies in the U.S.
For example, you could invest in this index through the Vanguard fund VOO.
The Dow Jones Industrial Average is a price-weighted index, meaning each underlying holding is weighted based on the underlying price of each stock or bond. The Dow Jones is a large-cap index holding the top 30 largest companies in their corresponding industry.
For example, you could invest in this index through the SPDR fund DIA.
The Barclays Aggregate Bond Index is a market-cap-weighted index of investment-grade bonds that trade in the U.S. The Barclay's Agg includes Treasuries, mortgage-backed securities, and corporate bonds. This index excludes treasury inflation-protected securities (TIPS) and municipal bonds.
For example, you could invest in this index through the iShares fund AGG.
Investors often benchmark their own portfolios against market indexes to compare results. This way investors have a method for determining their own portfolio performance, by comparing the return of their own portfolio to the market index.
If your portfolio consistently outperforms the most similar index to your portfolio, it might mean that your investing strategy is superior to just investing in the index.
Index funds are ETFs or mutual funds that track a market index. By purchasing this ETF or mutual fund, you are virtually buying a basket of underlying stocks or bonds. You can buy and sell index funds actively every day or hold on to them over time.
Many of these funds have small fees you pay as a percentage of your investment in order for someone to manage the fund itself. Index funds typically have low fees when compared to actively managed funds because of their simplicity.
When you purchase an equity index fund, you own a small piece of each underlying stock. Some of these stocks pay out dividends to investors.
The S&P 500, for example, holds the 500 largest companies in the U.S. Currently, over 80% of these companies pay dividends.
Over time, each of these companies will pay their dividend to the index fund. Then, the index fund itself will have a quarterly dividend payment to the holder of the fund. This allows investors to earn compound interest, check out our article on compound interest here.
One of the most famous investors of our time has been heavily involved with the creation and widespread acceptance of index fund investing. His name is Jack Bogle.
Bogle is the founder of The Vanguard Group, and has been an advocate for index funds since the 1970s. Bogle was one of the first fund managers to develop mutual funds that directly tracked broad market indexes.
The Vanguard Group is one of the largest asset managers in the world with a total of $5.1 trillion dollars in assets under management. Vanguard was founded on the principles of Jack Bogle, that investors should earn market returns over time by investing in low-cost broad market index funds.
One of the best books I've read about index fund investing is The Little Book of Common Sense Investing by Jack Bogle. This book explains the power of holding index funds over time. Bogle signifies the savings from choosing low-cost funds and taking a long term investment approach.
Index funds are a way for investors to gain broad market exposure to a group of stocks or bonds. Index funds are a great way for investors to easily diversify their portfolio.
When investors diversify their portfolio and hold a group of stocks rather than just one company, the overall risk of their portfolio decreases.
We have all heard the term “don’t put all your eggs in one basket”. This phrase is very relevant when trying to build a diversified portfolio to mitigate risk.
One of the fundamental theories in finance today is the Modern Portfolio Theory. This theory aims to explain how risk-averse investors can build a well-diversified portfolio to maximize returns given a set level of market risk.
In other words, the theory explains how a well-diversified portfolio of uncorrelated assets can earn greater returns as well as be less volatile over time when compared to individual companies.
The image above shows by increasing the number of holdings in your portfolio you can diversify away company-specific risk. As you hold more companies in your portfolio, you are less susceptible to individual risk from a single stock.
Thus you reach a point in your portfolio where the only risk you have is broad market risk. Market risk is the overall risk of investing in financial markets. These risks include volatility, political events, changes in interest rates, and recessions. Market risk is a risk that cannot be diversified away.
All portfolios have risk-reward profiles. You can measure these profiles using various metrics and ratios. The risk-reward of holding an individual stock in your portfolio is high because you are putting all your money in that one stock.
The risk is high, and the potential reward is high as well. That position could go up significantly or it could earn you a negative return. The risk is high because the potential volatility of your portfolio is high.
Now say you add one additional stock to your portfolio and you are now holding 2 stocks. By adding 1 more stock to your portfolio, you are reducing the portfolio’s volatility because the movement in price between the two stocks has the ability to cancel each other out. This reduced volatility (risk) is the basic fundamentals of diversification.
When we invest in an index fund, we are eliminating volatility caused by single stocks. Instead, we are generally investing in the market as a whole. This allows us to earn market returns while eliminating single company risk.
When we decide to invest our money, we have to make the decision of how to manage our portfolio.
Traditionally, there are two types of portfolio management; active and passive. These two types of management are very controversial in the investment community.
Personally, I use both of these investment strategies. When making the decision of active vs passive investing, we must first define the management styles and get a deeper understanding of how these strategies work.
Active portfolio management is a strategy that tends to be more dynamic. There are many different active management styles, but generally active portfolios tend to be more willing to change.
Active managers aim to beat the market over time. They may pick a benchmark index such as the S&P 500, and try to capture higher returns than the index over time.
An active manager will search for market irregularities and take advantage of events that will impact stock prices.
Political events, earnings releases, economic events, Federal Reserve decisions or breaking news events are some of the events that an active manager trading equities may try to exploit.
As there are many different active management styles, you cannot paint active management with a broad brush. Warren Buffett is one of the best active managers of all time. His company Berkshire Hathaway earned over 1,000,000% return from 1964 to 2015.
The S&P 500 increased 2,300% over that same time.
Buffett is in the 1% of active managers that consistently beats the market, and he's the best of the best. Buffett is considered an active manager, though he may buy a position and hold it for decades. Some active managers may hold a position for a few hours, others may hold a position for years.
Passive portfolio management is a strategy that is more strategic in nature. The goal of passive management is to earn market returns over time. A passive portfolio manager will aim to earn a return equal to an index, such as the S&P 500.
Passive management does not require a proactive approach or an extensive investment management team. For these reasons, passive investments are often lower in cost for the average investor. Using a buy and hold approach lets index fund investors earn market returns over a period of time.
Passive investors typically believe that there is no use in trying to beat the market because it is nearly impossible. This is why passive investors choose to invest in index funds, which will earn market returns over time.
A passive index fund aims to eliminate risk associated with individual stocks, sectors, and human error. The only risk associated with a passive index fund is the broad market risk.
Throughout his life work, Jack Bogle has explained using hard data how index funds outperform most active managers over time.
He explains that over 95% of active mutual fund managers fail to beat their benchmark index over time.
This is a significant figure and shows just how many investor dollars are chasing returns and falling short of their goal in beating the market. For similar reasons, Warren Buffett recommends that most people simply invest in a low fee index fund that tracks the performance of the S&P 500.
For the average investor, it is much more risky for someone to buy one individual stock than to buy a diversified index fund. When you are buying one stock, your entire portfolio correlates directly to one single company. You carry significant risk when you invest in 1 individual company. This risk is known as business risk.
Business risk is all the risks associated with one individual company. These risks include supply constraints, product line issues, management mistakes, or changes in capital structure. There are a variety of risks with buying stock of individual companies.
This is why so many investors choose to invest in broad market funds or index funds. When investing in an index fund, you use the power of diversification to reduce business risk to virtually 0. As you hold a variety of businesses, one single holding will have a minimal impact on your portfolio as a whole. The only risk left is broad market risk, which cannot be diversified away.
The biggest advantage of most index funds is the fee structure. Since index funds do not require a large investment team, they are very low cost.
Saving on fees over the course of years can add up to thousands of dollars in your pocket. Vanguard has an Index Mutual Fund the Total Stock Market Index (VTI) is a great example of a low-cost index fund with an expense ratio of 0.04%.
When compared to a typical 1% expense ratio that is commonly seen on actively managed funds, this can result in a discrepancy of hundreds of thousands of dollars over a person's lifetime.
For certain investors, index funds may hinder their investment strategy.
One of the biggest negatives of index funds is the lack of control you have over your portfolio.
For some investors, this may be a good thing and prevent them from making emotional investment decisions. For other investors who see an emerging opportunity in the market, they will not be able to potentially profit if they are invested in an index fund.
When you invest in an index fund, you are giving up control of your portfolio and giving all the control to the index itself. Your portfolio is virtually built by the index managers themselves. They are the ones who decide which companies to include in the index.
The index managers must decide which companies fall within the index metrics and meet the guidelines of the index. For example, a group of people decide which companies should be added to the Dow 30.
Index funds allow you to diversify your investments. However, some portfolio managers believe they can achieve the same amount of diversification with a fewer amount of stocks. These managers typically buy 20, 30, or 40 companies within different sectors and attempt to beat the return of the indexes. Many managers attempt to do this while maintaining broad portfolio diversification.
Other money managers may not believe in portfolio diversification at all. These investors prioritize investment performance over total portfolio risk. This type of active investing can be higher risk.
Another risk when investing in index funds is the misunderstanding of portfolio diversification. An investor who invests their entire portfolio in an index fund within a specific sector would not be considered diversified.
For example, if you allocate a single index fund for semiconductors to your entire portfolio you would have significant exposure to the fluctuations of the semiconductor market.
An S&P 500 index fund on the other hand provides exposure to hundreds of companies across dozens of industries and would provide much more thorough diversification.
It really comes down to your investment style. If you enjoy the researching and valuation of individual companies, then an index fund may not be an ideal choice. Individual stocks can earn high returns but also carry much more risk.
It is important that you understand the risks involved with a single stock before you commit capital to such a volatile investment. If you are a more passive investor and want to protect yourself from self-harm or choosing bad investments, then index funds may be a great option for you.
If you want to learn more about investing in individual stocks, here is our beginner's guide.
Investing Simple is affiliated with Betterment and M1 Finance.
An investor can purchase an index fund at virtually any online brokerage nowadays.
If you are a fee sensitive investor, M1 Finance offers prebuilt portfolios that will invest your money in low-fee index funds.
M1 Finance does not charge any fees to invest with the platform and they have a minimum balance of $100.
On top of that, you can take advantage of portfolio automation and set up automatic weekly or monthly deposits to regularly invest. Most passive investors do so through a retirement account, and M1 Finance offers these for free with a minimum balance of $500.
If you are looking for a little more portfolio guidance, Betterment could be a great option as well. Betterment is a robo-advisor that determines your ideal portfolio allocation through the use of algorithms. In exchange for this, they collect an asset management fee of 0.25%.
This is still extremely low when you compare it to industry peers.
Betterment offers other features such as Smart Saver, automated rebalancing and tax loss harvesting. Betterment invests your money in low-fee index funds.
If you want to follow the self-managed approach, you can buy ETFs through any brokerage these days. You can also invest directly into Vanguard funds on the website if you meet the minimum balance requirement.
Index funds offer great opportunities for investors. For the average person, investing in a low-cost index fund may be a great investment decision. Here is a brief overview of our main ideas on index funds:
Over time, index funds have proven to be a strategy that has a higher probability of success when compared to traditional investment strategies. Index funds provide the average-Joe investor with diversification and low fees, making indexing an attractive investment strategy for many investors.