Sunday, August 14, 2016

Intro to Investing in Index Funds

What is an ‘Index Fund’?

Index fund is a basket of stocks or bonds that follow a certain benchmark Index. A benchmark index is a standard against which the performance of an investment is measured. For example, S&P 500 is an American benchmark Index of 500 large companies and is probably the most popular stock index as it represents the broader health of US stock market and economy. Besides S&P 500, there many other Indexes that represent or focus other parts of the market such as Small Cap Stocks, Bonds, Dividend paying stocks, and many other benchmarks.

Investment firms create Index Funds that track these benchmark Indexes. An investor can buy shares of these Index Funds either directly from the investment firm or through their brokerage. These funds are normally traded on stock market as ETFs (Exchange Traded Funds) and sometimes even as Mutual Funds. ETFs trade just like stocks where an investor can buy or sell ETF shares during the normal hours of the market. Therefore, if I want to invest in the broader American large cap stock market, I would just buy shares in one of the S&P 500 ETF Index Funds such as (tickers): IVV, VOO, and SPY.

Benefits of Investing in an Index Fund
  • Instant diversification
  • Low cost
  • Passive investment
Investment in an Index Fund provides instant diversification across a basket of stocks or bonds. For example, investment in a S&P 500 Index Fund provides diversification across 500 US large cap stocks without having to buy each individual stock.

Since Index Funds follow a specific benchmark, they don’t require active management, and hence are cheaper to own than actively managed Funds. Which means less drag on the total return. This is also one of the reasons why Index Funds beat actively managed funds over long time. The high cost of actively managed funds has a compounding drag on the total return of investment. This is because the cost is normally calculated as some fixed percent of the total investment amount, and as investment grows, so does the cost. Also, actively managed funds have a higher turn-over rate (how often stocks within a fund are bought or sold), a high turn-over rate indicates active trading within a fund and can add additional cost for the investor.

The Index Fund’s management does all the work of picking the stocks. The management is responsible for annual or quarterly balancing of the fund as well as any dividends and capital gain payments to the fund investors. Since all the work is done by the fund’s management, the individual investor doesn’t have to do any work of picking or monitoring individual stocks. This is why investing in Index Funds is considered a Passive Investment and suitable for people who want to invest in stock market, but don't have the time or passion to research and pick their own stocks.

Downside of Investing in an Index Fund
  • Performance will not exceed the benchmark
  • No control over individual investments inside the fund
  • Slow to respond to benchmark changes

Since an Index Fund closely follows a given benchmark, the best it can do is meet the performance of a benchmark. This is only a disadvantage if the investor wants to beat the benchmark. For example, if I want to beat the overall S&P 500 market, I would not be investing in an S&P 500 Index Fund. Instead, I would be handpicking individual stocks in the S&P 500 that I think would outperform the broader market. 'Beating the Market' is the promise that most Active Fund managers/firms make, and why many people invest in actively managed funds or hire the service of an investment advisor. 

However, remember, there is no guarantee that actively managed funds will always outperform the market. Whereas, it is pretty much guaranteed that an Index Fund will provide the return equivalent to the benchmark market index it follows. 

When you buy a share in an Index Fund or any fund for that matter, you are buying a share in that fund and not in the individual stock. The fund’s management controls which stocks to buy or sell within the fund. Therefore, if a stock is removed from the benchmark due to under performance, the management of the Index Fund may not get around making the change until the end of the quarter or even a year. I don't see this as a big disadvantage mainly because the Index Funds are highly diversified across hundreds of stocks, and small number of stocks under performing should not have a major impact to the overall fund's performance.

Conclusion
Despite the downsides, the benefits of investing in a low-cost Index Fund out weights any downside. Not only an investor can save thousands of dollars in management and advisor fees, they can stay completely passive and let the fund track the overall market or a chosen benchmark. This USA Today article sums it pretty well on why Index Funds are better than Actively Managed Funds: 66% of fund managers can't match S&P results

Disclaimer: Author of this article is not a licensed/registered financial or investment advisor and does not provide investment advice. This article is for informational purpose only. Please use your own judgment or seek a licensed financial advisor before investing. You, the reader, bear responsibility for your own investment and financial decisions.

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