What exactly is an index fund?
Index Funds aka passive management
An index fund is a fund that tracks an underlying index/benchmark. For example, the Vanguard S&P 500 ETF (VOO) tracks the S&P 500 Index. The S&P 500 Index comprises of the 500 largest companies listed on the various stock exchanges in the United States. As of August 2019, the top 3 holdings in the S&P 500 Index includes Microsoft, Apple, and Amazon.
Note that the main objective of an index fund is to track its benchmark efficiently. That is if an index/benchmark hold 10% worth of Apple stocks, an efficient index fund that tracks the said index should also hold 10% of its fund in Apple stocks. Keyword being efficient. I will elaborate on what makes an index fund or ETF efficient in a separate article.
In a nutshell, an index fund is mandated to follow the index/benchmark as closely as possible, with as little deviation as possible. This is known as passive management.
For more information on VOO, see https://investor.vanguard.com/etf/profile/VOO
An index/benchmark is maintained by the index/benchmark issuer. For instance, the S&P 500 Index is maintained by the S&P Dow Jones Indices which is a division within S&P Global. Within S&P Global, there is a committee that determines the selection methodology for the securities that make up the index/benchmark.
The traditional index/benchmark is based on weighted market capitalization. That is, the securities’ weightage in the index/benchmark is based on the securities’ market capitalization. The higher the security’s market capitalization, the higher the allocated weight is for the said security. Market capitalization is the total market dollar value of the company. We can derive the market capitalization by taking the current market price per share of the security and multiple it by the number of outstanding shares.
The exact opposite of an index fund is an active fund. An active fund is one where a hired professional fund manager will actively select asset securities based on some analysis. Such analysis may include security, technical, fundamental, quantitative, qualitative, macroeconomic analysis, etc.
Simply put, the active fund manager will have the full discretion on which securities will go into the fund. Using the above analogy as an example, if an active fund is benchmarked against an index that holds 10% of Apple stocks, the fund is not obligated to hold 10% of its fund in Apple stocks for whatever reasons the fund manager deems fit. The active fund manager may even choose not to hold any Apple stocks in his/her fund. This is known as active management.
Note that the main objective of an active fund is to outperform its benchmark aka beating the benchmark. For example, if the benchmark perform 10% and the active fund performs 11%, the fund is said to beat the benchmark by 1%. Alpha (another common term in investing that you should know) which measure the relative performance between the fund and its benchmark, using the above example, is 1%. If the fund underperforms the benchmark, the alpha will be negative.
Now that we know what is an index fund and its direct counterpart (an active fund), you may ask yourself; what is the fuss with index funds?
#1 Index Funds are inexpensive
Firstly, most index funds are ‘significantly’ cheaper to invest relative to active funds. One of the costs of the investment is known as the Total Expense Ratio (TER). In short, TER is the total operating cost of managing a fund, which covers management fees, administrative fees, custodian charges, trading costs, employees’ salaries, etc. Note that TER does not cover your transaction costs of buying and selling of the securities nor does it take into account of taxes. If you are interested to calculate your total cost of investing, you should take into account of these costs (transaction costs and taxes), however, keeping track of them can be quite mind-boggling especially taxes. I will elaborate on how to keep your transaction costs low in a separate article.
Most index funds that should form the core of an investor’s portfolio would have a TER of less than 0.20% per annum (p.a.), excluding transaction costs and taxes. For example, VOO that gives an investor broad exposure to the US stock market would only cost an investor 0.03% p.a. (accurate as of August 2019), a tiny fraction compared to what an US-focused active fund would cost. That is, for every 10,000 dollars invested in VOO, 3 dollars will go to Vanguard’s pocket annually. Cheaper than a cup of Starbucks coffee!!!
#2 Active Funds on average underperform
Secondly, according to SPIVA (S&P Indices Versus Active), which track the performance of active funds, reveal that most active funds underperform its benchmark. The key takeaway from SPIVA is that over a long period (> 15 years), the probability of active funds beating its benchmark consistently is very slim. Keyword being consistently. To active fund managers’ credit, it is probable though difficult, that active managers can beat its benchmarks over the medium term (< 10 years), however as capital markets become more efficient over time, the probability of an active fund manager beating its benchmark diminish. I will elaborate on these (market efficiency and SPIVA) more in-depth in a separate article.
Note that most active funds (ex of some hedge funds), will still manage to collect their management fee regardless of the fund’s performance. That is, if an active fund underperforms its benchmark, the fund house will still collect its management fee (a subcomponent of TER). As to how the fund house could get away with this is beyond my comprehension.
#3 Index Funds are simple to execute
Lastly, an index fund is ‘simple’ in its execution and does not have the same level of nuances/complexity as an active fund. The complexity of active management varies across fund houses/funds. Depending on the fund house’s investment philosophy, some may adopt the ‘traditional’ Top-Down and/or Bottom-Up approach towards security selection, some ‘modern’ fund houses rely on a computer algorithm and some may adopt a combination of different strategies. The million-dollar question; which type of strategy will generate consistent alpha? Well, there is really no real way to tell.
Furthermore, professional fund managers, professional as they may seem, are human beings at the end of the day. They are exposed to the same biases, emotions and folly that all human beings experience. Look no further than to Long-Term Capital Management (LTCM). If there is anyone on this planet that can generate alpha consistently, it would the Nobel Memorial Prize-winning men behind LTCM.
For more information on LTCM, see https://www.investopedia.com/terms/l/longtermcapital.asp
The moral of the story is, why pay more in management fees for underperformance?
As always, take personal responsibility for your financial well-being and do your own due diligence.
Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.
Categories: Passive Investing 101