What is index investing?
The goal of index investing is to approximate the performance of stock market indexes through index funds. This investment method assumes that the stock markets are generally efficient.
For most individual investors, who do not have the temperament, skill, or time to practice value investing, I recommend investing in no-load low-cost index funds. Warren Buffett and David Swensen, among other famous investors, also recommend index investing for most individual investors.
Why should we invest in index funds?
Better performance: Everyone wants to outperform the market. The market, however, is mostly efficient and it is very difficult to outperform the market over the long term. According to Vanguard, index funds had better returns than 70% of actively manage funds. Some reports claim index funds outperform 80% of actively managed funds before taking fund expenses and taxes into consideration.
Low costs: Index funds do not require expensive fund managers or research staff, allowing them to keep management expenses low. Most index funds have low management expense ratio (MER; 0.09%-0.65%) and do not charge sales commissions (also known as "loads"). On the other hand, actively managed funds usually have higher MER (1-2%) and may charge loads of up to 6%. The high costs of actively managed funds put a drag on investor returns, and they must to outperform the index just to match the investor returns of no-load low-cost index funds. Given that most index funds already outperform actively managed funds before costs, after costs, it is practically impossible for high-cost actively managed funds to beat low-cost index funds.
Low portfolio turnover: Index funds have low portfolio turnover, so they spend less on trading transaction fees, resulting in lower management expenses. Low portfolio turnover also results in higher tax efficiency due to less realized capital gains. By minimizing losses to taxes, we will ensure maximum potential gain.
No "key person" risks: The performance of actively managed fund may critically depend on its fund manager, and the departure of the fund manager may significantly affect the fund's performance. Even with the same manager, Morningstar claims that up to 40% of professional managers deviate from their stated investment styles (this is known as "style drift"), so you may end up with a fund different from what you signed up for. Index funds, by their very nature, do not depend on the talents of a fund manager and will not suffer from style drifts.
Easy to invest and manage: By investing in only a few index funds, you can be instantly diversified across small, medium and large cap stocks, and across domestic and international stocks. You will have fewer things to track and it will take minimal time for you to manage your investments.
What are the potential drawbacks with index funds?
Index funds cannot outperform the index: Index funds aim to approximate the returns of stock market indexes, so they should never outperform the indexes. The maximum return index funds can achieve is the stock market return minus fund expenses. The only reason an index fund may outperform the index is tracking error. As we established earlier, though, it is very difficult for actively managed funds to consistently outperform stock indexes, so index funds outperform most actively managed funds over the long run.
Tracking error: Index funds aim to approximate the returns of stock market indexes, but due to cash holdings and sampling, they may deviate (both positively and negatively) from stock market returns. The tracking errors are generally very low, causing 0.05%-0.40% deviation from index returns, far less than the "beta" (volatility, or deviation from market returns) of actively managed mutual funds.
Market bubbles: Market bubbles are "systemic" and will be reflected in stock market indexes. Because index funds aim to replicate stock market indexes, they will inevitably experience the rise and falls of systemic market bubbles. Actively managed funds may try market timing to buy low, sell high, and avoid market bubbles. Unfortunately, actively managed funds have dismal records at market timing and are often actively involved in market bubbles.
Index composition changes: Stock market index composition may change over time due to changes in company capitalization, mergers and acquisitions, initial public offering (IPO) listings, or liquidations and delistings. These changes are usually announced ahead of time, and the stocks in question may rise or fall with the announcements prior to the composition changes. This can cause slightly higher buying prices and lower selling prices. The losses due to composition changes, however, are relatively small in broad market indexes and do not significantly impact their returns.
Index funds ignore business valuations: Index funds do not take into consideration business valuations when investing in stocks. They merely try to replicate the composition of the index. The assumption of market efficiency require market participants to actively value businesses and trade stocks at their fair values. Since the majority of stock market participants are active investors, for now, the stock markets are still mostly (though not completely) efficient. For professional investors have the temperament, skill, and time to practice value investing, they will be duly rewarded. For most individual investors who do not have the temperament, skill, and time, they will be better off investing in an index fund.
How do I invest in an index fund?
I hope I have convinced you that index investing is better than investing in actively managed funds, and that you are now ready to start investing in index funds. So how can you invest in index funds? There are two options:
Option 1: Regular index funds. Financial institutions, such as Vanguard and Fidelity, offer no-load low-cost index funds. You will need to open an account with them before you can begin investing. They may have a high minimum investment requirement you need to meet before you can open an account, but the requirement may be lowered if you enroll in their automatic investment program. A comforting factor for new investors is that you can speak to a representative before you begin investing.
Option 2: Index fund ETF (exchange-traded funds). ETFs are, as their names suggest, traded on stock exchanges. You can buy them through discount online brokerages to lower your costs. There are plenty of ETF tracking similar indexes, so you will need to do your own research on the management expense ratios and how well they track the indexes. There are no minimum investment requirements, but watch out for high brokerage expenses. You can also trade rather easily with ETF, so you must control your emotions and invest for the long-term.
Related posts:
- The principles of value investing.
- Minimize capital loss.
- Maximize the power of compounding.
- Pay yourself first.
Recommended reading:
- A Random Walk Down Wall Street by Burton G. Malkiel.
- The Little Book of Common Sense Investing by by John C. Bogle.
- Common Sense on Mutual Funds by John C. Bogle.
- The Bogleheads' Guide to Investing by Taylor Larimore, Mel Lindauer, Michael LeBoeuf.
References:
- Wikipedia:
- Vanguard: Indexing turns 30, and the revolution continues.
- John Bogle: As The Index Fund Moves from Heresy to Dogma . . . What More Do We Need To Know?
- San Francisco online: The best investment advice you'll never get.
- Free Money Finance: Why I Like Index Funds, Part 3.
P.S. This post was featured in the 151st edition of the Carnival of Personal Finance at Alpha Consumer.
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