What are Index Funds and how do they work?
Index funds are one of the fastest growing investment products. There are lots of reasons why, and this post will describe what they are. This post describes the basic way index funds are created and why their performance has been so good.
If you’re interested in considering why index funds work, this post is for you.
We’ll answer the following questions:
- What are Index Funds?
- How does the S&P 500 work?
- How can investors buy Index Funds?
- What is an ETF?
- Why do Index Funds work?
- Where should investors go for advice?
Let’s begin by describing what indexes are, and how index funds are made.
What are Indexes?
Broadly speaking, indexes are statistical measures or indicators. A stock market index measures a group of stocks to track their performance in a standardized way.
The standardized way indexes are maintained removes almost all “discretion” from decisions about how individual components make up an index. What to include, or not, is determined by the index “methodology” not anyone’s individual “judgment”.
The S&P 500 is the most widely followed stock market index, so let’s use it as an example of how indexes are created and maintained.
How does the S&P 500 work?
The S&P 500 Index tracks the performance of the 500 largest public companies based in the United States. In 1926, the Standard Statistics Company created an index tracking 90 stocks. Then in 1941, the company merged with Poor Publishing to form the research, statistics, and ratings company called Standard & Poors, also known as S&P. In 1957, the company created the S&P 500 Index to track the largest 500 stocks in the United States.
With some exceptions, the S&P 500 Index is composed of the 500 largest public companies in the United States. The weight of each company in the index is based on each constituent company’s market capitalization. The bigger the company, the higher its weighting in the index. Therefore, the weight of a company within the index is determined by the market price for its shares, and not at the discretion of an investment manager.
If Microsoft has a market cap of $2 trillion and McDonalds has a market cap of $200 billion; the weight of Microsoft will be 10 times the weight of McDonalds within the index.
At the time of writing, the two largest American companies, Microsoft & Apple, make up over 10% of the S&P 500 Index. Compared to the smallest 229 companies in the S&P 500 Index which combined make up less than 10%.
The way that indexes are standardized is one their strengths. They remove discretion.
Indexes promote simplicity
With some exceptions, the S&P 500 Index is easy to understand.
Simply take the 500 biggest companies and hold them in proportion to how big they are. As their share prices rise and fall day-to-day, index investors will ride the same wave. When a company falls below the top 500 largest companies in size over a pre-determined time, or when a company merges with another one or gets bought out (or goes bankrupt), S&P simply adjusts the index by removing the old company and replacing it with the largest one not already in the index.
S&P makes money by licensing their index methodology to fund companies who then create products for investors to use.
What’s an ETF?
ETF stands for Exchange Traded Fund. It refers to investment funds that are traded on exchanges just like stocks.
Once an index company has created a useful index, investment fund companies then create mutual funds and exchange traded funds (“ETFs”) that replicate the returns for investors. ETF companies buy all 500 stocks in their correct weights according to the index, and then offer the index fund to investors as an ETF.
Examples of fund companies offering ETFs that track the S&P 500 are Vanguard, iShares, and State Street.
To buy or sell ETFs, investors make trades like they would any other stock on the exchange. When an investor buys shares of an ETF tracking the S&P 500, they are buying a small fraction of a portfolio of 500 stocks. This is an advantage of index funds, they provide easy diversification.
Own 500 companies with one investment
Investors in an S&P 500 index fund become owners in all 500 companies making up the index. The portfolio of an S&P 500 Index fund includes all the 500 stocks that make up the index in proportion to the size of each company.
Let’s say you invest $100 into an S&P 500 Index fund, and Microsoft represents 5% of the index. This means you will own $5 worth of Microsoft stock inside your $100 investment (along with 499 other stocks making up the remaining $95 of your investment). If PepsiCo represents 0.5% of an index, it means you’ll own 50 cents of PepsiCo for each $100 dollars you invest in the index fund.
Let’s say the other 499 stocks that make up the index remain the same, but Microsoft, which represents 5% of the index gains in value by 10%. This means your $100 investment will now be worth $100.50.
Index funds are low cost, passive investments
Index funds themselves don’t need to make many transactions since most of the time they passively hold the index constituents and let nature run its course. This enables index fund managers to offer their services for a very low fee, almost free.
This is another advantage of index funds, their low cost.
Since index funds are passive investments that are mostly buy & hold, it makes them very cheap to operate. No need to buy a fancy office or a sophisticated computer system to analyze data to determine which stocks to buy or sell. Index funds simply follow the formula set out by their respective index. This keeps costs down.
Since index funds generally make very few transactions, the investment companies that offer index funds also offer very low fees for investors.
For example, the BMO US Equity Fund is a mutual fund investing in US stocks. It is not an index fund, and it charges an annual fee of 2.49%. By comparison, the cost of the BMO S&P 500 Index ETF charges 0.09%. This means that a mutual fund investing in a universe of US stocks is charging a fee that is 27 times higher than an index fund tracking the same group of stocks.
Do Index Funds actually work? Are returns good?
Indeed, index funds are becoming so popular because they work so well. Investors are turning away from active investment managers towards passive index funds because the results are so good.
Let’s keep in mind that the stocks inside index funds tracking the S&P 500 are the biggest companies on the planet. Think Microsoft, Apple, Amazon, Walmart, etc.
But low fees and diversification are not the only reasons why index funds work.
Here are three main attributes that make index funds successful:
- Low Cost
- Emotionless
- Passive
#1 – Index Funds are Cheap
We know that most active investment strategies fail to beat their index benchmarks, so the additional costs involved are simply a drag on results. Every penny of fees you pay will reduce your returns. Index funds are virtually the cheapest investment you can make.
#2 – Index Funds Avoid Psychology & Emotion
This is a big one, and not obvious at first.
Since index funds are based on pre-determined criteria and not based on discretion or judgment, index funds can free us from our own biased decisions.
We know that investor psychology is a big drag on returns. Identified cognitive biases such as confirmation, loss-aversion, and overconfidence cloud our decision making.
Since the decisions about what an index fund might buy or sell is pre-determined and not subject to human emotion, index funds avoid the drag on returns from investor psychology. The dispassionate style of indexing contributes to the superior returns.
However, there is one problem with index funds when it comes to investor psychology.
The decision to buy or sell an index fund itself is still in the hands of each investor.
So, to avoid the temptation of “timing the market”, index fund investors should invest based on a plan with pre-determined criteria.
For example, consistently investing a pre-determined amount on a certain day each month into an index fund no matter where the market is trading is a good strategy. Don’t leave yourself the discretion of when to invest, or else you may find yourself prone to investing biases that will drag down your results.
#3 – Index Funds encourage long-term investment
Index funds support long-term investors with a buy & hold mindset. The investments inside of a typical index are static. But, we could also refer to this as the “never sell” nature of index funds. The fact that index funds themselves “never sell” their own investments might be their secret sauce.
To understand how their static nature contributes to the superior performance of index funds, we need to understand where the returns on a portfolio of investments usually come from.
The returns of an investment portfolio usually come from a small number of holdings.
This means that most of the stocks in any stock portfolio will perform somewhere around the average. Some will fail pitifully, and a small number of stocks will do fabulously well. It turns out that the small number of stocks that dramatically outperform the average will be the ones that contribute the most to the overall portfolio’s returns in the long-run.
Think about the “80/20 rule” (the Pareto Principle). And consider the fact that a bad investment can only go to zero, whereas a good investment might double, triple, or even rise by 10 times its initial value.
So, what does this mathematical fact have to do with a long-term mindset or index funds?
Well, professional investment advice says to re-balance a portfolio periodically so that the investments are roughly balanced with each other or back to an initial target allocation. Practically speaking, this means periodically selling investments that have risen and then buying investments that have fallen.
Sounds ok, right? Well it turns out, re-balancing a portfolio guarantees it will underperform the average. Why?
By cutting off the winning investments in favour of those that aren’t as good, investors are simply limiting their own returns. Remember, a small number of stocks that dramatically outperform will contribute the most to a portfolio’s overall return. Without those big winners, a portfolio is guaranteed to underperform since an index like the S&P 500 never “re-balances” and always lets its winners ride.
Indexes like the S&P 500 don’t re-balance and this is one of the keys to why they perform so well.
Capturing all the performance from the stocks that dramatically outperform is essential because overall returns are skewed in favour of those stocks.
Mean regression applies to coin flips, not stock prices.
How about a fun story instead?
There was an investment advisor named Kirby back in the 1970s and 1980s. Like any good investment advisor, Kirby would sometimes recommend new stocks to buy and other times recommend old stocks to sell.
One day, one of his client’s notified Kirby that her husband had died. She had inherited his account and wanted to merge it with her own.
When Kirby saw the husband’s account, Kirby was shocked to see the husband had taken all of Kirby’s buy recommendations over the years. The wife was passing along Kirby’s hot stock tips to her husband for free.
But, there was a funny wrinkle. The husband stealing Kirby’s recommendations only followed the buy recommendations and never the sells. In fact, the husband never sold any stock, ever. The husband was a dutiful buy & hold investor.
The result was, that after a few decades of stealing Kirby’s buy recommendations, the husband’s account had dramatically outperformed his wife’s. The wife had taken Kirby’s buy recommendations, and his sell recommendations.
How could only taking the buys and never selling be the reason for superior results?
It turns out that most of the stocks that Kirby had recommended over the years had done ok. Some were dogs, but a few of the stocks Kirby had recommended did remarkably well.
One stock had done so well that made up more than half of the husband’s entire portfolio value. Whereas many investors would have sold this stock to “re-balance”, the husband never sold. He just let nature run its course.
Since the husband never sold, and only bought, the husband was able to capture the entire returns of the market without limit.
Lexington Leaders Trust
The story of Kirby isn’t the only example of a dedicated buy & hold strategy working out so well. Other investors like Warren Buffet hold forever too.
Another fun example is the Lexington Leaders Trust. Click here to read this story.
It wasn’t apparent when index funds were created, but their passive buy & hold nature gives them a huge advantage over active investors.
Buy & hold works well economically, but also provides simplicity.
So, how do you invest in index funds?
To assemble a portfolio of index funds, you can consult an investment advisor or open an account with an online brokerage. This might be daunting for many investors.
This is where our family office can help. If you’re sick of riding the emotional roller coaster with your investment portfolio, our advice will bring you greater confidence and peace of mind.
We help our clients avoid sales pitches. We do this by drafting an investment policy for you that will reflect your values & goals. This way, you can easily deflect unwanted sales pitches. Then, we will implement your strategy by setting you up with an advisor or platform that has your best interests at heart. Not one that bribes you with “free” lunches or tickets to the game.
We take a fee for the work that we do. We don’t give out hot stock tips.
We encourage our clients to take a long-term approach to investing. To avoid trading and stick to a buy & hold strategy instead. We encourage our clients to make high-quality blue-chip investments.
Index funds are a great tool for buy & hold investors.
Investors can purchase index funds including ETFs from almost every licensed stock broker or online brokerage service including Fidelity, Schwab, Robinhood and many others in the US and including RBC Direct Investing, TD Direct Investing, Scotia iTrade, BMO Investorline, CIBC Investors Edge, Wealthsimple, and CI Direct Trading among many others in Canada.
To find out more about how we help our clients navigate the world of investing including index funds, please contact us.