Investing in Index Funds
An In-depth Look at the Pros and Cons in 2018
Berkeley, California – April 3, 2018
A while ago when driving to Palo Alto, I tuned into NPR, which was featuring an hour-long discussion on the trend of investing in and the benefits of Index Funds. When I heard the introduction, I paused. It was one of those moments when I realized that the “index fund party” was over, or soon would be. There is too much money going into very specific and finite areas of the stock market with inflexible parameters.
But before I tell you why, let me back up and go over a few key definitions so that we all have the same understanding of terms:
An INDEX FUND is an investment whose underlying stock or bond holdings consist of the same stocks or bonds that make up a specific index, e.g. S&P 500, Russell 2000, Russell 1000 Value, Barclays Aggregate Bond Index, etc. An index fund can be purchased in the form of a Mutual Fund and/or Exchange Traded Fund (ETF).
MUTUAL FUNDs and ETFs refer to the structure of the investment vehicle which holds the stocks or bonds. They both pool the money of many investors. The money manager managing the mutual fund or ETF will then take that money and invest in the stocks of the specific index. For example: you want to purchase the S&P 500 (which I don’t recommend for reasons I will get into later), but you don’t have nearly enough money, time or attention to buy the 500 stocks that make up the S&P 500 in the same proportion as the S&P 500. You can, however, buy an S&P 500 Mutual Fund or ETF. You effectively are buying the S&P 500 with each share of the Mutual Fund or ETF you purchase.
One other thing to note because so many people get this point confused: Just because something is a Mutual Fund doesn’t make it expensive and just because something is an ETF doesn’t make it cheap.
PASSIVE INVESTING is an investment strategy that aims to maximize returns (not out-perform) over the long run by keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that potentially occur from frequent trading. These funds will buy the stocks of a specific index or the entire market.
ACTIVE INVESTING is highly involved. Active investors typically look at a broad pool of companies to invest in and then select only a few based on various criteria. Usually, active investors are seeking short-term profits. Active investing also allows money managers to adjust investor’s portfolios to align with prevailing market conditions.
While I believe in PASSIVE investing, beware of INDEX FUNDS.
Put simply, too many people have hopped on the bandwagon and there is too much money moving to Index Funds. The constituents (companies making up the index) of an index are reviewed regularly and often companies are added or subtracted from the Index. (I remember when Microsoft and Apple were not part of the S&P 500 and now they make up a combined 6%.) When this happens, all the of index funds have to execute trades to realign with the index. They are all in the market at the same time, trading the same stocks, and even though they are investing in big companies with lots of liquidity, index funds have become big enough to step on themselves in the market, thereby reducing returns.
Additionally, index funds only give you a small subset of the entire market potential. The IMF shows that global stock values are worth approx. $75.3 trillion. The US accounts for 53% of that number, International Developed Countries account for 35%, and 12% Emerging Markets. The S&P 500 accounts for 19% to 20% of the global capital markets. By investing only in the S&P 500, you are not taking advantage of the entire US markets or the 80% of the remaining global market.
If you want a well-diversified portfolio, which we suggest, and you are keen on index funds because you listened to the same NPR radio show I did, I must underscore that you will need to invest in multiple indexes. For example, (and this is NOT a recommendation; this is for illustration purposes ONLY): Russell 1000 Value, Russell 1000 Growth, S&P 500 Mid Cap Value, S&P 500 Mid-Cap Growth, Russell 2000 Value, Russell 2000 Growth is typically what I see (more if you are using FinTech platforms). That means you are paying for six transactions before you even get to international, emerging markets or bonds (not to mention other important asset classes).
So, what do we recommend? For appropriate stock (and some bond) exposure, we recommend using Market Funds, which can be purchased in Mutual Fund and ETF form. You will capture the value of the entire global capital markets easily, cheaply and with less tax and trading cost impact. We also suggest that you read all prospectus very closely to understand the trading policies of the fund or ETF and how efficiently they are allowed to trade into a stock—especially low volume small company stock, as well as any risk mitigation strategies.
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