Index Funds Explained – “The Investment That Makes the Most Sense”
This is a fact: active managers of funds aren’t really “great” at their jobs. ‘Active managers of funds’ means individuals who operate “hedge-funds” and pick various stocks that aim to generate “big” returns for their investors. These fund managers often charge a fee for managing these funds.
In 2016, 66% of active managers couldn’t beat the “market index”. Over a 15-year period, 90% of fund investors also failed to beat the “market”.
You may be a bit confused as we’re throwing around terms like “market”. But what does it mean when we say, investing in the market means purchasing a “passive” index fund? In this article, we’re going to break down the jargon on these terms, and explore what legendary investor Warren Buffet meant about index funds when he suggested it “makes the most sense practically all of the time” for the average investor.
Introduction to Index Funds, Stocks & ETFs
| Index Funds | Stocks (Equity) | ETFs | |
| What are they? |
An index fund is a portfolio of securities that mimics the performance of a financial market index such as the Standard & Poor’s 500 Index and the Nasdaq 100. |
A stock, also known as equity, represents fractional ownership of a company.
Units of stocks are called ‘shares’. Shareholders are entitled to the company’s assets and profits equal to the amount of shares they own. |
An exchange-traded fund (ETF), is a pooled investment ‘basket’ that tracks a particular index, commodity, bonds, or other assets and operates similarly to a mutual fund. |
| What are their benefits? | Indexing is a passive form of investing. This strategy is common among people who lack the time to pick and value stocks individually.
Indexing also reduces the risks of completely diminishing their capital since the investor is mirroring a particular index i.e. S&P 500. |
Investors that own common shares in a company have the right to vote in shareholder meetings and the right to company profits (dividends). Majority shareholders have the right to steer the company’s direction by selecting its board members. | The difference between a mutual fund and ETF is that an ETF can be purchased and/or sold on the stock exchange just like regular stocks.
Mutual funds, which pool money from other individuals, usually have annual and first-time charges. ETFs also offer the investor opportunities to invest in markets with minimal trading fees and fund expense ratios as low as 0.03 percent. |
| Examples | Standard % Poor 500 (SPX), Dow Jones Industrial Average (DJI), Nasdaq Composite Index (IXIC),
BURSA MALAYSIA KLCI INDEX (KLCI) |
TESLA INC. (TSLA), META PLATFORMS (FB), FGV HOLDING BERHAD (FGV) | ProShares UltraPro QQQ (TQQQ), ProShares Ultra VIX Short-Term Futures ETF (UVXY), Financial Select Sector SPDR Fund (XLF) |
The benefits of Index Funds
- Lower Expense Ratio
Index funds do not require constant human supervision as their goal is to simply mirror the market, hence they tend to request lower management fees (aka expense ratio). This is unlike mutual funds that are actively managed in order to beat the market, in turn coming with a higher management fee for fund managers tasked to choose your investment. It is shown that a lower expense ratio is better recommended for saving and in turn, can generate a generous amount of inflow in the long run. For example, an ETF (exchange-traded fund) offers the lowest expense ratio among all other types of index funds.
- Diversified Portfolios
It is always wise to invest in various portfolios rather than individual stocks. A particular index fund is made up of multiple companies, which means capital invested in the portfolio is exposed to all diversified sectors and stocks. Thus, an investor can seize the probable returns on a larger segment of the market through a single index fund.
- Tax advantage
When a fund is set to sell a stock for profit, the difference between the initial purchase price and its final sales price is known as a capital gain. Funds with a higher turnover ratio derived from a higher capital gain will result in higher taxes by the fund manager. This isn’t the case for index funds, however, as they have a low turnover ratio from being passively managed by the fund manager. The fewer trades that were placed in a year concluded that lower capital gains were being generated for distribution to its shareholders.
The point of discussing these is to demystify some of the terms you may find when financial jargon is thrown around. These are the three most common investment avenues you may find. We can’t tell you what to invest in, that depends on your financial goals as well as your risk appetite.
What is an Index, and exploring the “American Index” and “Malaysian Index”
S&P 500
S&P stands for Standard and Poor. The S&P 500 is a stock market index that tracks the stocks of 500 large-cap U.S. companies. It represents the stock market’s performance by reporting the risks and returns of the biggest companies. Investors use it as the benchmark of the overall market, to which all other investments are compared.
Companies in the index include Apple, Microsoft, Amazon and Tesla.
KLCI
Kuala Lumpur Composite Index consists of the largest 30 companies listed on the Bursa Malaysia stock exchange as determined by Bursa rules requirement. The progression of the KLCI index value also preserves the historical movements of the Malaysian stock market.
Companies in the index include Maybank, CIMB and Tenaga.
(Source: TradingView)
S&P 500 VS. KLCI: Performance Comparison
| 1-Yr | 3-Yr | 5-Yr | Total | |
|
S&P 500 |
+6.40% |
+50.95% |
+86.62% |
+143.97% |
| KLCI | -1.20% | -2.04% | -9.51% |
-12.75% |
Investors may be surprised to know that returns for KLCI and S&P 500 index funds are not very similar if they compare their annual returns. We can see in the previous chart and also in the table, that the S&P 500 has provided the most returns to investors since the early 2000s.
“If you can’t beat ‘em, join ‘em.” That is essentially what index investors are currently doing. The investment objective of an actively managed mutual fund is to outperform market averages — to earn higher returns by having experts strategically pick investments they believe will boost overall performance. As a result, investors may choose an actively managed fund over an index fund in an attempt to outperform the index. However, investors can achieve greater diversification, and potentially greater performance, by selecting their own allocations.
However, it’s worth noting that while during this period the KLCI was negative against the US market, the KLCI actually outperformed the US Index during the 80s and 90s.
| Jan 1987 | March 1997 | Percentage Increase | |
|
S&P 500 |
226.28 Points | 793.17 points |
318% |
| KLCI | 275.65 Points | 1261.45 points |
357.62% |
This is largely due to Malaysian companies benefiting from rapid economic growth during the period of the 1980s and 90s with foreign markets bolstering the Malaysian equity market as well. The KLCI was particularly hit, after this period, with the index falling to a low of nearly 300 points (or 76%).
Currently, the Malaysian stock market has yet to reach its peak of around 1850 points in June 2014. This downturn could be attributed to the lack of “growth stocks” in the index, such as the technology companies in the United States like Apple, Alphabet (Google’s Parent Company), and Tesla.
Growth stocks, refer to stocks that trade at higher valuations, and the implication of this is they may seem expensive right now (if we start using metrics), but these high valuations may be fairly valued in the future.
(Source: https://americasbestpics.com/picture/visualizing-the-insanity-tesla-vs-world-659b-668b-cap-ford-wKvhkF3G8
Some may find that Tesla’s price is outrageous, given that other carmakers combined make more “revenue” than Tesla (46.5 times more), but Tesla proponents would argue that in the future, Tesla cars become so popular and supply chain issues are overcome, that they will be worth that much in the future.
Now that we’ve compared the US to Malaysia, we can zoom in further on two Index Funds in the US.
SPDR S&P 500 ETF (SPY) vs Invesco QQQ Trust (QQQ): Performance Comparison
(Source: TradingView)
|
Mar 1999 – April 2022 |
1-Yr | 3-Yr | 5-Yr | Total |
|
SPDR S&P 500 trust (SPY) |
+6.40% | +50.95% | +86.62% |
+241.02% |
| Invesco QQQ Trust (QQQ) | +0.57% | +77.51% | +155.30% |
+545.01% |
In this chart, we compare the SPDR S&P 500 ETF to the Invesco QQQ Trust, an exchange-traded-fund (ETF) that tracks the Nasdaq 100 Index. The Nasdaq 100 Index is composed of a “basket” of the 100 largest most actively traded U.S companies on the Nasdaq exchange. Companies included deriving from various industries except for the financial industry.
Since technology accounts for 56% of the index’s weight, the Invesco QQQ Trust is susceptible to immense volatility and high risk. This is why we notice ‘Tech stocks’ in the Nasdaq often going higher than the Standard and Poor’s Index during bull markets.
Bull markets refer to when markets and share prices overall are rising. Bear markets refer to when markets are down (usually by 20%) and share prices overall are falling.
However, a con of the QQQ ETF is that during a bear market, investors would see their investment decline substantially. The QQQ ETF could technically be considered as more “expensive” and an increased risk. A big argument is that diversifying one’s portfolio is safer given that stock prices move at random, and the QQQ only represents the 100 largest companies in the US, and in comparison, an S&P 500 ETF would represent 500 of the largest companies in the US.
If you’re wondering which ETF to invest given the benefits, it largely depends on your risk preference and financial goals. However, we hope that we’ve illustrated why in the words of Warren Buffet, index funds do “make sense most of the time”. While past returns are not indicative of future returns, index funds mean that one is “invested” in the market, without having to individually pick stocks. In the long run, a 10% average return is higher than a traditional savings account and it beats inflation.
How to invest in an index fund?
If you’re wondering how to invest in an index fund, it’s rather simple:
- Create a Brokerage Account. You can choose one that operates completely online (see Rakuten, MPlus in Malaysia) or ask around friends/family for a remisier’s contact.
- Pick an index you would like to track, such as S&P 500 or Nasdaq 100.
- Select a fund that tracks your index.
- Purchase shares of an index fund.
References :
2022. The Motley Fool|3 reason to invest in Index Fund| [online] Available at: <https://www.fool.com/investing/how-to-invest/index-funds/why-invest/>
2021. The balance|Risk and Benefits of Index Funds | [online] Available at:<https://www.thebalance.com/why-invest-in-index-funds-2466447>
Fanklin Templeton |INDEX FUNDS MEANING, BENEFITS & HOW TO INVEST IN INDEX FUNDS| [online] Available at:<https://www.franklintempletonindia.com/article/index-funds-meaning-benefits-how-to-invest-in-index-funds-io04og33/index-funds-meaning-benefits-how-to-invest-in-index-funds>
2022. CNBC| Index fund are one of the easiest way to invest- heres how they work| [online] Available at <https://www.cnbc.com/select/what-are-index-funds/>
Chen, J. (2022, April 15). Exchange-traded fund (ETF). Investopedia. Retrieved April 16, 2022, from https://www.investopedia.com/terms/e/etf.asp#toc-what-is-an-exchange-traded-fund-etf
Fernando, J. (2022, March 7). Index funds: How they work, pros and cons. Investopedia. Retrieved April 16, 2022, from https://www.investopedia.com/terms/i/indexfund.asp
Hayes, A. (2022, March 5). What is a stock? Investopedia. Retrieved April 16, 2022, from https://www.investopedia.com/terms/s/stock.asp
Thune, K. (n.d.). Compare Holdings and Performance. Total Stock Market Index vs. S&P 500 Index. Retrieved April 14, 2022, from https://www.thebalance.com/total-stock-market-vs-sandp-500-2466403#:~:text=The%20difference%20between%20a%20total,indexes%20represent%20only%20U.S.%20stocks.
Norris, E. (2022, January 2). QQQ stock trading risks and rewards. Investopedia. Retrieved April 17, 2022, from https://www.investopedia.com/ask/answers/061715/what-qqq-etf.asp#toc-qqq-pros-and-cons
2022. Nerdwallet |Index Fund: How to Invest and Best fund to choose| [online] Available at: <https://www.nerdwallet.com/article/investing/how-to-invest-in-index-funds>
Researchers: Nasir Ali, Tan Dei Lonn, Hariz Shah
Reviewer: Muhammad Bahari
Editors: Mindy Liew, Julia Yazid
