The Joy of Index Investing
I’m a big fan of index investing, It’s the secret weapon that gives the average Joe the ability to play with and soundly beat the big bully’s of the investment world.
What is an Index?
Companies comprising an Index have to be ordered by a criteria, usually market capitalisation. However indexes can also be ordered by other values such as dividend yield. So the S&P200 you hear about on the news each night is an index is made up of the 200 largest companies on the Australian stock exchange, the banks, the miners, Woolies, Telstra etc.
Whats the difference between an index fund and a managed fund
Managed funds, funnily enough, are ‘managed’ by a human being, the fund manager. He will usually get paid handsomely irrespective of how they perform.
An index fund on the other hand does not need a sharp suited dealer, it simply tracks the index using a computer algorithm and so does not need paying big fees.
There is a raging battle between active (managed funds) and passive (index funds) – to sum up, the fund managers are losing, albeit slowly. We bang on a lot about this at MensMoneyHealth, but index funds usually thrash the arse of managed funds in performance over the long term and that’s why we love em.
How can I invest in the index?
Funds which track indices come in two main flavours, traditional index funds and exchange traded funds or ETF’s.
|Traditional index Funds||Exchange Traded Index Fund|
|How to buy||Can be purchased from your bank or investment house||On the stock market, so need a broker account or within your superannuation account|
|Management costs||Generally slightly more cost than ETF’s||Generally slightly cheaper costs than traditional index funds|
|Dividends||Allow reinvestment||Usually pay out dividends|
|Transaction costs||Usually zero||Broker dealing fees|
We especially love ETF’s as they can be traded just like any other shares in your trading account or even your superannuation account at low cost.
Set and Forget
Like an individual company, you don’t have to monitor how well it’s doing in the market compared to it’s competitors or glean insights from the company reports each year. Sit back and relax and let thousands of workers in hundreds or even thousands of companies worldwide slowly make you richer.
Multi headed Hydra
Like the mythical multi headed snake beast from greek mythology (or Jason and the Argonauts at least), whereby severing one of the snakes another would grow back in it’s place, Index funds also have magical regenerating powers. An individual company’s share prices may fall to near zero, but then they will simply fall off the index to be replaced by the next biggest company.
An index fund will always end up being the made up of the top companies. This also means that super fast growing companies (think Netflix) will push less worthy companies out of the way and hey presto you automatically get a piece of the action in your fund.
An index of will never drop to zero and take your investment with it, unlike say Enron. However this is not to say that indices are not volatile and can’t crash in value like during the GFC, it’s just that as long as you can wait it out they will always bounce back eventually.
Buying an index tracker is a cheap, efficient way to maximize horizontal diversification. However this is really only ‘horizontal diversification’ which is when you hold different instances of the same asset class. This avoids localised company or sector-specific risks, particularly with shares.
For example, by buying the Vanguard® US Total Market Shares Index ETF (VTS) you are actually buying shares in 3,796 companies worth over US$500 billion! How incredible is that!? You get to own a little bit of Apple, Google, Microsoft ….. and the list goes on, in one simple transaction.
Cheap as chips
Low cost funds especially ETF’s tend to have very low percentage fees, especially when compared to managed funds. For example the Vanguard® US Total Market Shares Index ETF available in Australia has a fee of 0.05% which equates to a fee of $50 a year for $100,000 invested. Whereas a managed fund with fees of 2% a year will cost you $2000 for the same $100,000. And this differences can add up to a huge amount over the years, see our super ripoff article here.
Buying (or selling) an ETF only involves one trade with one cost say $20. Buying all of the stocks in the index eg the S & P 500 would involve 500 buy trades at $20 a pop = $10,000 cost
Moving between superannuation plans or switching brokers can be done much easier and with much lower cost than say if you owned 50 stocks of companies. With a fund you simply sell and pay one trading fee, (say $10) with a portfolio of stocks you have to sell all 50 individually (50 * $10 = $500)
Get stuck in
Unlike individual companies you don’t need investigate the ins and outs of the company books and decide whether this company is likely prosper in the future. Indexes are broad and are great for beginner investors. You can get stuck in straight away with low cost ETF’s of one of the major developed markets e.g. S&P 500, FTSE 100, S&P200 or the whole of Europe without having done much in depth research.
Sidestep country taxes
Some ETF’s are domicled in tax favourable countries which means you avoid paying your home country’s specific tax. For example buying Reckitt Benkiser on the UK stock exchange will incur a stamp duty of 1.5%. So you would be charged an extra 150 GBP on 10,000 GBP. However buying the Vanguard Irish domiciled FTSE 100 index tracker has no such tax. Again these fees can add up over a portfolio of individual companies.
You get what you don’t pay for
Index funds have been shown to beat the majority of managed funds over longer time frames. Lower fees of index funds definitely contribute here. Here is my favourite example of how index investing available to anyone can beat the best managed money [buffet versus hedge fund]
Dividend reinvestment plan
Like some companies, some funds allow you to have the dividends automatically buy more shares of the index fund without you even having to lift a finger. The ultimate in low maintenance investing.
Access to wordwide markets
You might not be able to buy Chinese companies from your broker or super fund, but you will probably be able to buy an index fund that gives you exposure to the Chinese stock market index.
Some funds send you end of tax year reports that make it a cinch to complete your tax return. Have you ever tried totting up the dividends and capital gains for a bunch of individual shares? I have, it’s not great entertainment – why make tax time taxing?
So here are our main reasons for loving index tracker funds. If you don’t already use them, we suggest you chuck out those ripoff managed funds and enjoy the benefits of simply tracking a low cost index.
Tell me about your experiences with index trackers? How do you use them?