Investing in Index Funds: A Comprehensive Guide for Beginners

Allowing you to track the broad markets with far less risk of blowing up!

An index fund tracks the performance of a market index, a hypothetical portfolio of investments that typically represent a market (or part of one).
Index funds closely match the index's returns and are usually suitable for long-term investments.
Index funds are usually (but not always) traded on the exchange as ETFs.

Diversify! Diversify! Diversify! That’s what all the articles on basic investing always talk about; you can’t go through one piece without seeing this term. It’s about reducing the risk exposure in your investment portfolio and while it sounds difficult to do, diversifying your portfolio isn’t a laborious task.

In fact, diversification gets accomplished simply through unit trusts and ETFs! One such type of fund that you should know is the index fund.

What is a Stock Market Index?

A stock market index is a theoretical collection of shares that are publicly traded on an exchange.

An example is the Standard and Poor’s 500 Index (S&P 500), which tracks the performance of 500 of the largest companies listed in the US.

Another example is the FTSE 100, which tracks the 100 largest companies listed in the UK. Both of these examples are of indexes that cover a country, but indexes can narrow their scope to cover a specific industry or market segment.

Usually, market indexes get shown with an index value, determined by its corresponding companies’ share prices. Note that there are many ways to calculate the index value because you can assign different weightages to the chosen companies, i.e. different weighting methods.

Here are a few common weighting methods:

Market capitalisation weighting
Price weighting
Equal weighting
Fundamental factor weighting

Read more about weighting methods here.

Market index values track the performance of the market as a whole. From the two examples above, the market indexes typically contain the biggest market capitalisation companies in their area of focus, which usually have the highest weightings. They can act as a stand-in for the corresponding market’s performance. This is why you may regularly see major market indexes working as benchmarks for portfolio or investment performances.

What are Index Funds?

Index funds are basically portfolios that match the component weightings of a specified index. As the component weights of the index fund match those of the index, when the index value changes (e.g. increases by 2%), the value of the index fund value will also change by almost the same percentage (i.e. increases by 2%). Through this method of “indexing”, index funds track an index and mirror its value changes.

Once an index fund is set up, it requires minimal intervention or management.

If a company gets added or removed from the underlying index, there will be a need to change the index fund’s composition accordingly. This is a rare but not uncommon occurrence. There is no need for any active trading whatsoever. This keeps the total expenses of the fund low, making it easier to track the underlying indexes.

ETFs and Unit Trusts

Index funds can come in the form of ETFs or unit trusts, (also known as mutual funds, especially in the US). Due to their passive nature, index funds are commonly found as ETFs traded on exchanges, making them incredibly accessible! Note that not all ETFs are necessarily either index funds or even passive funds since ETFs are, by definition, any fund traded on an exchange. But usually, they are.

Why invest in Index Funds?

Index funds are popular amongst investors, but why?

1. A Cheap Method of Diversification

Index funds are a great way to diversify your holdings without needing to fork out a huge amount of cash on (choosing and then) buying many individual shares. An index fund will invest in a range of companies from various sectors or geographies, depending on the underlying index. Instead of individually purchasing shares in each of these companies, you can buy just a single unit of the index fund to gain exposure to all of them immediately. This reduces your cost significantly and, realistically, gets you a far greater level of diversification.

2. Low Fees

As index funds are passively managed funds that simply aim to replicate the performance of an index. There is no need for portfolio managers, analysts and all the enormous overheads related to them. Index fund managers do not need to do any stock-picking, and trades are executed more or less automatically. Hence, due to the low cost of management and general expenses, fund management fees are significantly lower when compared to actively managed funds.

When looking at both active and index funds’ details, management fees, along with the fund’s operational expenses, such as trading fees, auditing fees and legal fees, are reflected in the total expense ratio (TER) or net expense ratio.

The TER is shown as a percentage, referring to the fund’s assets used to cover administrative and operating costs of maintaining the fund annually. For example, if you had invested $100,000 into a fund with a TER of 0.5%, you will pay $500 per year. Hence, if the market performance of the portfolio for your first year was 2% (i.e. $2,000), your net return becomes reduced to about 1.5% (i.e. $1,500).

The TER for passively managed funds like index funds is low, typically much less than 1%. In comparison, active funds may charge up to 2.5% or even more!

3. Ease of Trading

Due to most index funds existing as ETFs, they are easily bought and sold on exchanges. They are tradable at any time during the trading hours of the exchange. Due to the exchange acting as a central trading ground for investors, liquidity is usually high, and investors shouldn’t have a problem executing trades.

Note that the price of the traditional over-the-counter (non-exchange-traded) unit trusts only get updated at the end of the day.

4. Ideal for Long-term Investments

Due to its low fees, "low" risk and steady growth, index funds are ideal for long-term investors. As the index fund tracks a market index, you will never significantly underperform the market. Of course, that also means that you will never outperform it. However, under the theory that markets typically outperform individual stock picks in the long run, it may be more stress-free to simply invest in the market for your future goals. One of the greatest investors in history, Warren Buffet, recommends investing in index funds for retirement savings!

Passive funds such as index funds also tend to outperform active funds in the long run. According to Standard and Poor’s SPIVA research, for the five years ending on 31st December 2021, more than 80% of active funds (in each of the ten regions reported on) underperformed the regional index. Notably, in Canada, 94.32% of active funds underperformed.

It is a common observation that while active funds may have a higher likelihood of outperforming the market in the short run, passive funds have historically generated higher returns in the long run. Even leaving out the reasonable possibility of poor, emotional or sheep-like decision-making by active managers, their much higher total expense ratios hurt investors by compounding over time the same way interest rates on loans do!

Sounds good? If you’re thinking about getting index funds and unsure what to add to your portfolio, consider speaking to an investment professional!

What Are the Downsides of Index Funds?

Like any other trading strategy and investment product, index funds have their fair share of critics. Let’s hear what some arguments against index funds are.

Will Never Beat the Market

Because index funds aim to replicate the risk and returns of the market, you will never outperform it. Hence, investing your money in index funds means that you are surrendering the possibility of making huge profits on your investments above and beyond what the general market will deliver. Ultimately, it depends on what your financial objectives are and whether you’re confident in beating the market through other financial instruments or not. (Hint: it's not easy)!

No Loss Protection

The market doesn’t go up indefinitely in a straight line. We’ve seen recessions, market upsets and global pandemics that throw markets into chaos. If the market does well, then you’ll make money with your index funds, but if the market takes a tumble, then your investment in index funds will fall as well.

Lack of Flexibility

A major issue with index funds is that you have no say in the fund's constituents. You can choose which fund to invest in, but you cannot change its components to your liking, as you can with your portfolio. Thus, if you’re keen to have exposure to a specific index, but not as confident about a particular company/companies in the index itself, you can’t do anything about it if you buy the corresponding index fund.

It can get pretty frustrating that you can’t act on any knowledge you have; the weightings and components of an index fund are entirely out of your hands! That said, if you really do not want individual names or sectors in your overall investment portfolio, you could, where allowed, enter an appropriately sized short position in those names. Though, this can be an expensive proposition over time, given the cost of borrowing. A better alternative would be to look for another index fund that already excludes those names, e.g. green or ESG funds.

Market Concentration Risk

Passive index funds have grown massively from huge flows of investor money switching into them from active funds. This may present a problem on the horizon with so much money effectively chasing the same few largest names.

The endgame and timeframe, if any, is unclear, but there may well come a time when the violent mispricing of individual shares because of blind, market cap based selling could provide some interesting long-term or defensive opportunities (particularly if there is an aggressive, broad market selloff).

INDEX FUNDS 101. COMPLETED. ✅

Sources:

Disclaimer

Content is intended to be used and must be used for informational purposes only and should not be relied upon as financial or other professional advice.