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What Are Index Funds?
According to Investopedia, an index is a method used to track the performance of a group of assets in a standardized way. Indices measure the performance of a group of securities intended to replicate a certain sector of the market.
A good example is the S&P 500 index which tracks the performance of the stocks of the 500 largest corporations by market capitalization as listed on the New York Stock Exchange(NYSE).
How Do You Invest In Them?
Since an index tracks the performance of a market sector, you cannot invest your money in the index. You can only invest in the index indirectly through an index fund or an exchange-traded fund (ETF) that mirrors the performance of the index.
An Index fund is a mutual fund that holds stocks of all the companies of a certain index and seeks to match the performance of the index.
Exchange-Traded Funds(ETFs) trade like stocks on the stock exchange and they mirror their respective indices and their prices are a reflection of the ETF’s Net Asset Value(NAV).
ETFs and Index Funds have become so common nowadays that almost all major fund companies offer their ETFs or Index Funds that mirror the performance of a certain index.
For the S&P 500 Index, for example, fund companies that offer an ETF that mirrors the performance of the index include Vanguard, SPDR, iShares Core by BlackRock, Invesco, and many more.
Index funds include; Fidelity 500 Index Fund(FXAIX), Schwab S&P 500 Index Fund(SWPPX), Vanguard 500 Index Fund Admiral Shares (VFIAX), and many more.
Differences Between Index Funds & ETFs
Index Funds and ETFs have many similarities rather than differences. The only notable difference is that ETFs can be traded at any time of the day when markets are open and hence are affected by daily volatility activity.
Index funds on the other hand can only be traded at the price set at the end of the day. Hence unless you are focused on intraday trading, there isn’t much difference between ETFs and Index Funds.
Advantages of Investing in ETFs
Most ETFs issue dividends. These may be issued monthly, semi-annually, or annually depending on the ETF.
Investing in stocks through index funds is a lower risk investment compared to buying individual stocks. Unlike a single stock where your returns are affected solely by the performance of that company, an index fund has several companies. A few well-performing companies can average a great positive return.
3. Good Long Term Returns
“Put your money in an index fund and hold it for 20 years.” That’s the most common advice that comes with investing in index funds and for a reason.
4. Exposure to the World’s Top Companies
A good index like the S&P 500 has the top 500 companies in the United States of America. Investing in such an index will allow you to get a piece of the huge profits being made by the leading corporations in the world.
5. Little Research is Required
If you invest in stocks, you know the analysis that comes with good investing. You have to go through annual reports, and earnings reports, and try and look for market corrections in your bid to find great companies to buy.
Indexing is called passive investing for a reason. You only have to identify the market sector that you want to invest in, get an index that tracks its performance, and put your money in an ETF or an index fund that replicates your standard index.
Disadvantages of Investing In Index Funds
1. Limited Gains
The one thing that used to put many investors away from investing in index funds was the limited gains. This is because when you invest in an index, you will get the average return of the companies making up the index. This means that the returns of the top-performing companies will be weighed down by the returns of the poor-performing companies.
This implies that people who can choose the best-performing stocks will have higher returns than people who invest in the index fund.
2. Exposure to Large Cap Stocks Only
Investing in Index funds that replicate the performance of only large-cap stocks may leave you out on the huge returns that come with the growth potential of small-cap stocks.
The S&P 500 is the most standard index that is used to track the performance of the stock market. This is because it has many companies from almost all market sectors.
However, there are other indices that track the performance of other market sectors. Most notable are the Nasdaq 100 and the Dow Jones Industrial Average.
In an interview with CNBC, Warren Buffett gave his best advice on how to invest in stocks:
“Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time. The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently.”Warren Buffett
The Rise of Passive Investing
In 1975, John Bogle started the First Index Investment Trust. Like any other new idea, it was heavily opposed by opponents who dubbed it “Bogle’s folly.” No one thought that the majority of investors would be okay with getting the market average returns that were to be realized from index funds.
As they say, there is nothing as dangerous as an idea whose time has come. It turns out John Bogle was a genius.
Bogle’s fund which was later renamed Vanguard 500 Index Fund crossed the $100 billion milestone in late 1999. As of 2019, the United States has seen more money invested in passive funds than in active funds. More than $11 trillion is now invested in index funds.
Bloomberg reports that more than 50% of US investments are now passive and both domestic and foreign passive investments may overtake active investments by 2026.
The Impressive Performance of Index Funds
In 2021, the S&P 500 returned an average of 29%. Only 3 hedge funds outperformed it. Even in the short term, where active investors ought to outperform the benchmarks, they still couldn’t. In the long term, it becomes even harder.
In 2021, the S&P Indices Versus Active(SPIVA) scorecard showed that over 79% of fund managers underperformed the S&P 500.
“SPIVA found out that more than 95% of all domestic active stock fund managers had underperformed their respective S&P benchmarks in the past 20-year period through 2021. In U.S small caps, nearly 94% of active fund managers lagged the S&P SmallCap 600 benchmark. Even active management’s record in foreign markets over the past 20 years raised red flags. Inquisitive investors might take note that almost 93% of international stock fund managers weren’t able to beat their respective S&P indices.”
Can You Beat The Market?
Hedge funds are managed by finance professionals who trade stocks for a living. What makes you think that you as an individual investor can do better than them while you focus on the markets part-time?
Maybe you stand a chance.
Individual investors have more advantages over professional fund managers. Fund managers spend most of their time focusing on short-term market movements and short-term goals that may help them win in the short run but lose in the long term.
Before you celebrate, you are no better at picking stocks than monkeys.
There’s overwhelming evidence that even professional investors are no more likely to beat the market than monkeys throwing darts at securities insights.