An Introduction to Index Funds
Updated: Nov 14, 2020
An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor's 500 Index (S&P 500).
There. That's the intro. Blog post done.
Just kidding. One sentence doesn't really help you understand what this investment type is all about. No doubt you'll still have questions relating to just about every second word of that first sentence. That's perfectly normal. I had the same reaction when I first came familiar with the term in 2019.
When most people hear the term "investing" they automatically think of super smart academics on Wall Street, a bunch of crazy charts on huge TV screens, and filthy rich stockbrokers. Ultimately we tend to fear the term and think we're not smart enough to participate.
That couldn't be farther from the truth, especially for index funds. I'm here to tell you that anyone, yes I mean anyone, can invest in the stock market. And it's not hard OR scary.
How Index Funds Work
There are two types of investing methods; active or passive. Active investors try to pick and choose stocks that aim to beat the average return of the market, while passive investing aims to mirror the return of a stock market index. Index funds are arguably the most common form of passive investing.
Index funds are mutual funds - bundles of investments, like stocks & bonds - that track the performance of a market index, like the S&P 500, which tracks the 500 largest companies in the US, and the ASX200, which tracks the 200 largest companies in Australia. These indexes are metrics that measure the value of a group of stocks over time. Each stock is weighted, usually by market value, so larger companies affect the value of the index more than the smaller companies.
Benefits of Index Funds
1. Low Cost
The annual fee charged by all mutual funds - including index funds - is an "expense ratio". Usually the expense ratio is a percentage of the total asset value you have invested. So if you have $10,000 with a 1% expense ratio, you'd pay $100 per year to own it.
Actively managed mutual funds often have higher expense ratios, usually between 1 to 2% because the fund managers are responsible for picking and choosing investment, ultimately aiming to beat the average market returns. It's marketed as "higher fee for a higher return". This rarely turns out to be true.
On the other hand we have index funds, which are passively managed. They just tick along without the need for a portfolio manager to do much at all and therefore there is not much to charge you for. These savings get passed onto you in the form of lower expense ratios.
Many brokerages offer very low expense ratios for their index funds, ranging from 0.15% down to 0.03% and Fidelity now offers a 0% expense ratio for it's large-cap index fund FNILX. So on that same portfolio of $10,000, you could pay $15, $3, or even $0 per year to own it in our examples. Fees really do add up!
Probably the best thing about buying into an index fund is the instant diversification you get. For example, when you choose a fund that tracks the S&P 500 you are getting exposure to the top 500 companies in America.
To get the same diversification through individual stocks, you'd have to buy at least one share of each of the 500 individual companies that make up the S&P 500 index. This would be rather expensive and not really practical for the average investor.
Diversification helps spread out your risk and makes it less likely that you will lose money in the market. The performance of the index will fluctuate up and down over time, but your money is spread out over 500 companies in the S&P 500 example, meaning if one company takes a dive there are 499 other companies that can absorb the shock.
3. Low Stress
Analyzing individual companies, reading balance sheets, performance reports and listening to earnings calls, all with the aim of choosing a stock that will go up in the long run, takes a lot of time and effort. I don't know about you, but I'd much rather spend the hours of the day with friends & family than combing through piles of research trying to pick a winning company.
For the most part, index funds can be a "set-and-forget" type of investment. You pick a few different funds that give exposure to the majority of world's economies, allocate an amount of money each month and invest consistently into the funds for the next 10, 20, 30 or even 40+ years.
You will have to rebalance your portfolio from time to time to ensure your asset allocation isn't getting out of whack, but the time it takes to do this is minimal, especially when compared to managing a portfolio of individual stocks. This simplified investing approach often means less stress.
Drawbacks of Index Funds
1. They're Not All That Exciting
"Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas." - Paul Samuelson.
I'm gonna say it, investing for long term wealth creation is boring. You have a few funds that you throw a consistent amount of money at each and every week, fortnight, month or quarter, and let it grow. There's minimal trading when it comes to index fund investing. You simply buy, and hold. That's it!
2. Market Returns Equal Your Returns
Just about everyone has heard about Bitcoin, and the explosion it's had since 2009. Bitcoin is a cryptocurrency that was first valued at $0.0008 per coin, but has increased to over $13,775 USD per coin as of November 2020. That's an astronomical increase!
This isn't normal though. Bitcoin is considered a highly speculative asset, which basically means it's more risky than other types of investments. This type of asset isn't included in most index funds. In index funds, you're typically investing in high performing companies with a strong track record of performance like Coca-Cola, 3M, Johnson & Johnson, etc. Although there are index funds that track small and mid-cap companies as well if you'd like to get exposure to the smaller guys.
When you're buying into index funds, you're buying average market returns. So if the market (S&P 500 in our example) returns 7% for the year, your investment will grow by 7% as well. If it goes down 3% for the year, you will also see your portfolio dip by 3%. Notice I didn't say "lose 3%"? That's because you don't lose money until you sell. Offloading your assets when the market is declining is the worst possible time to sell and should be avoided if you can help it.
There are times in history when the market has returned +30% in one year, but the average over the long term is about 7% when adjusted for inflation.
If you're in the game to make a bucket load of money in a few short years, index fund investing probably isn't for you. Just remember though, chasing higher returns comes with higher risk. While it is possible to "beat the market" in the short run, history has proven that barely anyone can do it consistently year over year.
Other Types of Index Funds
The most well known type is the stock index fund, which as the name implies, tracks a stock market index, such as the S&P 500 like we've mentioned previously.
There are also bond index funds, commodity index funds, and index funds that attempt to replicate various segments of an industry, like real estate, or the economic health of a country, like the All Ordinaries Index, which attempts to replicate the state of the Australian economy.
Bond Index Funds
Bond funds in general are a security that provides cash to a government or company in return for a security that has a specific maturity date. At maturity, the bond holder may cash in the bond for the face value plus interest.
Example: Vanguard Total Bond Market Fund VBTLX
Commodity Index Funds
Commodity index funds follow specific commodities markets and commodities futures. These index funds provide opportunities for less experienced investors to invest in a market that has a reputation for being complex, risky, and best left to professionals.
An advantage to investing in commodities index funds is that, historically, commodities fluctuate independently of stock and equities because commodities fluctuate in response to supply and demand. This provides an investor with a more diverse portfolio.
How to Get Started Investing Using Index Funds
Before explaining how to get started, I think it's important for you to recognize that you are likely already investing into the market through your retirement accounts like 401(k), IRA, Roth IRA, Superannuation, or ISA, depending on which country you live in.
More than likely if these accounts are set up by your employer, they will be actively managed mutual funds, which will charge a higher fee due to the active management component. You should find out exactly what your investing in through these funds and make sure they are right for you, your risk tolerance and overall investing goals.
You may find you wish to make tweaks to these existing accounts first, like switching from the default "balanced" asset allocation to an "aggressive" approach if you have quite a few years before you plan to retire.
Regardless of what you choose to do with you pre-existing accounts, the steps below will be your guide to getting started with index funds.
1. Choose a brokerage
Depending on where you live in the world you will have access to different brokerages. A brokerage is just a fancy name for a firm that deals with transactions on account of the client (you). Many firms offer advisory services but this will usually come at a cost to you, and with index fund investing it's unlikely you need to pay for this type of advice.
Some of the most popular brokerages include: Vanguard, Charles Schwab or Fidelity for the US, CommSec for Australia, and Questrade in Canada, to name a few.
2. Open an account
Now that you've chosen a brokerage you have to open an account with them. Think of it as opening up account with any bank as it's basically the same process.
For those in the US this could be an IRA (Individual Retirement Account), a Roth IRA (a tax free growth IRA), or a standard taxable account.
In Canada this could be an RRSP (Registered Retirement Savings Plan - similar to the US 401(k)), a TFSA (Tax Free Savings Account - similar to a Roth IRA), or a standard taxable account
In Australia there is really only Superannuation and a standard taxable account. There is no equivalent to a Roth IRA where contributions grow tax free. The American 401(k) is probably the most similar to the Australian Superannuation account.
3. Deposit money
You can connect your bank account to your brokerage account so you can easily transfer money or even set up regular auto-deposits.
4. Choose funds
Once money is in your brokerage account you can "place a trade" by picking which index fund or funds you want to invest in and "buying" the amount you want.
For example, Vanguard offers the fund VTSAX which is their version of a total US stock market index fund for the current price of $82.18 per share as of November 2, 2020. If you had $1000 to spend you could get 12.16 shares of this fund.
Also, don't judge a "good buy" by the price of a share. A 10% rise on a share that's worth $10 is the same as a 10% rise on a share that's worth $1000. What you care about is the growth percentage, not the share price itself.
Here's a simple image I created that may help you understand the steps we've just walked through.
This has been quite a long post about the ins and outs of index funds, so I'm glad you've made it this far! By now you should have a basic understanding of what index funds are and how they can help you build wealth slowly over time without the stress of trying to understand the complexities of the financial markets or picking individual stocks.
Index funds can be a great low cost way to spread your risk over hundreds or even thousands of companies across the globe, and deliver reliable market returns over the long term. The power of compound interest will cause your investment contributions to snowball and grow to a point where your money is making more money than you are! And that, my friends, is the ultimate goal.
As usual, please hit me up with any questions. I know that investing can be a confusing or daunting topic, so I'll do my best to answer any questions you have.
Blake - FIRE with a family