Index Funds

It can be considered as a subset of mutual funds

An index fund is a type of investment vehicle that enables investors to generate passive income.

Any fund works by pooling money from a large group of investors and subsequently investing them in various asset classes, including equities or bonds, depending on its strategy. 

It can be considered as a subset of mutual funds. However, a key difference between index and mutual funds is that the latter are actively managed, whereas the former are passively managed. 

When the NYSE has thousands of tradable securities, it can sometimes be difficult for new investors to decide which assets to purchase. This is why these investors turn to managed funds- they can have institutions work their money by paying a small fee. 

Generally, the strategy of this type of fund is not to buy and sell or constantly trade assets to generate returns. Instead, it aims to mirror the portfolio of an index (hence the name).

You can think of an index as a basket of assets where the performance of each asset is tracked (more on this later).

Different index funds will track different indices, and it is up to the investor to decide which fund is suitable for their investing goals. Although the United State's most famous market index is the S&P 500, there are thousands of indices that all track a particular sector itself. 

Investors can purchase these funds through their brokerage accounts online (such as Vanguard or TD Ameritrade). Over the past decade, they have become very popular investment vehicles due to their benefits. 

What are these benefits, and why do investors even want to invest in these funds? 

There is some history to this investment vehicle. Let's go behind its rationale and how it became popular over time. 

a brief history

Stock markets are dynamic, with billions of dollars exchanging hands daily. Although it is impossible to understand or predict market movement completely, investors who could realize as much of it as possible would have the potential to generate serious profits.

Before indices were invented, it was difficult for investors to measure "the market" as a whole. Some stocks went up, others went down, but no one understood whether there was a bullish or bearish sentiment (among other things). 

This is why in 1896, a financial journalist named Charles H. Dow invented the Dow Jones Industrial Average (DJIA). He published the average price of 12 popular stocks, most of which were industrial companies, because this was shortly after the industrial revolution.

The logic behind the DJIA was that investors could use the change in the average price to gauge the overall change in the market. In a way, if the DJIA was rising, investors took it as markets were rising, and vice versa. 

To this day, you can still find the Dow Jones Industrial Average index. However, its constituents are likely to have changed significantly from the past and now incorporate 30 stocks instead of just 12. 

Since then, many indices have been introduced, all representing a specified category. For example, the S&P 500 index tracks the performance of the top 500 companies in the United States and covers roughly 80% of the entire country's market capitalization

The FTSE 100 also tracks the top 100 publicly listed companies on the London Stock Exchange (LSE). However, indexes do not track only countries; you can find sector-related indices such as the Dow Jones US Technology Index, which covers the US tech industry.

A common (and controversial) topic among many finance professionals surrounding capital markets has always been this: do professional money managers even outperform stock market indices? 

Studies have shown that, on average, many hedge funds or institutional investors actually do not outperform the S&P 500. Perhaps they might get a good year where returns have skyrocketed. However, most of them post lackluster average returns in the long run.

Before it existed, investors would invest in mutual funds, where a professional money manager would select securities to invest in. The fund manager would consistently monitor and rebalance its portfolio to increase returns. This is called active management. 

However, when studies have already shown that institutional investors cannot beat the market over the long term, many people questioned the functionality of mutual funds. 

Mutual funds often subject their investors to fees. For example, there will be sales commissions when an investor wants to buy into a specific fund. Furthermore, investors face a yearly expense ratio because they pay someone to manage their assets consistently. 

Investors are subjected to these charges regardless of whether the fund outperforms market indices, posts the same return, or even loses money. Therefore, when fund managers have historically shown poor track records, charging fees on top of damages to investors' returns.

Subsequently, people realized that if even professionals lose to the market, why not simply invest in the market? This is where it came in - institutions started creating a fund that mirrors the constituents of a popular index and allows investors to buy into the fund. 

This way, if investors bought these funds, their returns would be similar to an index's. For example, there are index funds that track the S&P 500, and investors who buy into the fund would be able to gain returns that are very similar to the S&P 500. 

Because these types of funds mirror the portfolio of an index, there isn't any portfolio manager to actively select the securities. Instead, the assets that go into the portfolio have been predetermined and don't change much. This is called passive management. 

More about index funds

This has become very popular investment vehicles over the last decade (and with good reason). Many investors, including Warren Buffet, have been advocates of index funds and believe that this investment vehicle is the way to grow your wealth for most people.

Let's go over some of the benefits behind this type of investment vehicle: 

  • Diversification- the benefits of diversification have been widely discussed in the financial world. Investors should never put all their eggs into one basket.

It allow investors to purchase a single investment vehicle representing a basket of securities. As a result, their exposure to each security is minimized, and they would never lose too much money even if a security drops significantly in value.

  • Passive management- Unlike active management, investors don't have to consistently monitor their portfolio, look at a company's latest earnings announcement, and frequently stare at price charts. 

Instead, simply buy, hold and forget. It generally relies on the broader influx of capital to generate returns. If an investor sells his position in Tesla stock and reinvests it into Netflix, the S&P 500 index will still capture all that movement of capital (and so will the fund). 

  • Low management fees- they generally charge lower expense ratios than mutual funds. This makes sense because there isn't any portfolio manager actively selecting the securities that go into the portfolio. 

However, although management fees are lower, it isn't zero. Because of this, these investment vehicles will always have returns that trail behind the index it mirrors, assuming there isn't any tracking error.

This would be in contrast to the sales trader at Morgan Stanley or the asset manager at Fidelity, who spent hundreds of hours studying to pass the Chartered Financial Analyst (CFA) exam. Yet, it is likely that the market and that asset manager end up with an average return over the long run. 

There aren't many downsides to this investment vehicle. However, some caveats are worth mentioning before deciding that index's are the right investment vehicle for you. 

Here are some things to consider:

  • These funds are generally considered safe, where your wealth is protected, and it will take a lot to reduce significantly. However, because they are incredibly diversified, your gains are limited. 

Therefore, you can never expect to make 10,000% returns in this kind of fund as you would invest in cryptocurrency or NFTs. While many crypto investors have sustained losses, they have the potential to make large profits, whereas that will never exist within any heavily diversified product. 

  • There is a lack of flexibility with these types of funds. If you have done some research and found that certain stocks are undervalued, you are unlikely to increase your exposure to that stock with this investment vehicle. 

Although it wouldn't be too much of a hassle, you'd have to purchase those stocks by yourself on your brokerage account. 

  • Lastly, the limited gains can sometimes be unattractive because it is considered safe. Although the S&P 500 has an average return of 10% annually, not every index fund will generate equally attractive returns.

Furthermore, earlier, this investment vehicle relies on growth and the broader influx of capital to generate returns. This also implies that it is not risk-free and it is not shielded from recessions. 

Index fund vs. mutual fund vs. exchange-traded fund (ETFs)

Many amateurs will confuse this with mutual funds or ETFs. You will also see many institutional investors refer to certain investment vehicles interchangeably. Therefore, let's review some differences between index, mutual, and exchange-traded funds.

It is a subset of mutual funds. The main difference is that some professional asset manager actively manages mutual funds. In contrast, index funds are passively managed where the fund follows a predetermined strategy and mimics a specified index. 

However, index and mutual funds are similar in that they are only traded at the end of the day. This is because the funds' price depends on its net asset value (NAV), which will only be calculated when the trading day ends. 

A result is that all investors who want to purchase shares of the mutual fund will pay the same price, which is the NAV or the value of the fund's net assets divided by the total number of shares outstanding. There is no market price; everyone will pay the same price daily.

Many investors will use index and exchange-traded funds interchangeably. Practically, they are almost the same thing. ETFs are another type of investment vehicle that investors can invest in, and they are exchange-traded in the sense that they can be bought and sold on an exchange. 

The similarity between the index and exchange-traded funds is that they are both passively managed. ETFs also represent a predetermined basket of securities that investors can buy into. Most ETFs will also select securities that mimic an index. 

However, the key difference lies in the way they are traded. ETFs can be bought and sold during trading hours because they are exchange-traded. This also implies that similar to stocks, an ETF's share price will fluctuate daily and have a market price.

This differs from index funds that do not have a market price and are only traded at the end of the trading day. The price of funds (index or mutual) generally depends on their net asset value, which will only be calculated when trading halts. 

Example of Index Funds vs. ETFs

Confused? Don't worry. Most people were at the beginning too. Let's review some examples to see the difference between indexes and ETFs. This example will look at investment vehicles that track the S&P 500. 

A famous fund is the Schwab S&P 500 index fund. This fund aims to mirror the returns of the S&P 500 by mirroring the S&P 500's constituents. As shown in the image below, Schwab classifies this investment vehicle as a type of mutual fund. 

Because the Schwab S&P 500 index fund is a type of mutual fund (not an ETF), it is NOT traded on an exchange. Investors who want to purchase this investment vehicle must go through specific brokerage firms (in this case, Charles Schwab Corporation). 

On the other hand, another famous investment vehicle that tracks the S&P 500 is the Vanguard S&P 500 ETF (VOO). As the name suggests, this ETF mimics the S&P 500 constituents. 

This is an ETF. You can look at ETFs almost the same way you could stock- they are exchange-traded and have a market price. The critical difference is that they comprise more than one company. 

Note

If you notice from the image above a sentence that says "also available as an Admiralty Shares mutual fund," that's the Vanguard version of a fund that "tracks" the S&P 500. The fund is called Vanguard 500 Index Fund Admiral Shares (VFIAX).

The VFIAX tracks constituents similar to the S&P 500, but due to licensing reasons, the fund is not allowed to name-drop the S&P 500. However, its returns are identical to the S&P 500, and its website recommends them as an alternative to ETFs. 

Key Takeaways

  • These are an investment vehicle that enables investors to purchase a basket of securities in a single share.

  • They have become popular investment vehicles because they are passively managed and provide returns that are often better than actively managed funds.

  • Because these funds are passively managed, they often command lower expense ratios to investors.

  • While there are many similarities, they should not be confused with ETFs due to the critical differences in how they are traded.

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Researched and authored by Jasper Lim | LinkedIn

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