Are Index Funds A Good Investment?

Are Index Funds A Good Investment?

A common question that exists in the minds of investors is, are index funds a good investment? This question is not a surprising one given the huge numbers of investment products today. There are lots of arguments for and against individual stocks, mutual funds, commodities, etc. Not just the sheer number of investment products, but the existence of a large number of strategies is a source of confusion

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This post discusses the key benefits of index funds over other types of funds as well as individual asset class investments like stocks. These points will help you decide whether these funds are a good investment option for you. A key advice is this. Don’t just follow someone else’s advice in devising your investment strategy. Make your own decisions based on the information you learn. This post will help you in a great way.

The first section is a very important one. This section compares the passively managed funds to other forms of active funds. This section will answer your queries regarding whether index-tracking funds are better than traditional mutual funds.

1 Index Funds Better Than Active Funds

Many investors have started believing that index funds are good if not the best investments. A Moody’s report of February 2017 outlined the aggressive growth of passive funds. Before seeing the details of the report, you should learn the difference between two types of managed funds. The two types are the following.

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  1. Actively Managed Funds
  2. Passively Managed Funds

Now you will see a brief description of each of these two types.

Actively managed index funds:

Active Management of Index Funds
Active Management

Traditional mutual funds are managed by experts. They buy and sell assets frequently. Their objective is to beat the indexes. These managers oversee tasks including rebalancing portfolios, optimizing fee and tax expenses.

Passively managed index funds:

Passive Management
Passive Management

Passively managed funds don’t require close monitoring. Each fund tracks an index. The percentage of an asset in the fund’s portfolio will match that of the index. For illustration, let there exist an index “X&Y 500” with the following composition.

Shares of company A 30%
Commodity B 10%
Shares of Company B 25%
Shares of Company C 25%
Shares of Company D 10%

An index fund that tracks “X&Y 500” will have investments in the same proportion. (There are some exceptions which we will see later.)

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For example, if you have invested $10,000 in some “X&Y 500 Fund”, your investment will be split as shown below.

Shares of company A 30% of $10,000 = $3000
Commodity B 10% of $10,000 = $1000
Shares of Company B 25% of $10,000 = $2500
Shares of Company C 25% of $10,000 = $2500
Shares of Company D $10,000 = $1000

Now that you know the difference between active and passive funds, let us get back to the Moody’s report.

According to the report, by 2024, the passive funds will surpass the active funds in asset value. In 2017, the share of passive funds was 30% among overall managed funds. Many show interest in active funds for two prominent reasons.

  1. Lower fees.
  2. Better returns.

1. Lower fees

Index funds don’t require intensive management like active funds. Less number of managers and advanced technology have rendered operations less expensive. A fund provider doesn’t have to pay high salaries. Less workforce reduces administrative and other office related expenses. The savings in operating costs are passed over to customers in the form of lower fees compared to active funds.

2. Better returns

A report from S&P Global changed a wide-spread perception about active funds. The report compared the performance of active funds to indexes over 15 years.

Only 10% of the fund managers were able to beat the indexes. More than 90% trailed behind popular S&P indexes (large, mid and small cap).

What does the above data mean to an investor? Anyone who invested in passive S&P index funds for 15 years (by 2016’s end) would have beaten another person invested in active funds. The winning probability (viewing S&P index funds) is 90%.

There were also other studies that shifted the preference of investors from active to passive. These studies were widely publicized in media.

2 Diversification Reduces Risks

Diversification Reduces Risks

Common wisdom by many great investors is not to put all eggs in one basket. Sure you can gain if you are good enough to pick individual stocks of companies that beat the market. But the probability of choosing such a stock is very less. No supercomputers or no statistical analysis techniques can predict a winning stock with hundred percent accuracy. To analyze and to pick market beaters from among average stocks takes time and knowledge. Not everyone reading this post is a full-time investor. You have other important jobs in life too. Hence, diversification should be your strategy to eliminate risks.

How exactly diversification eliminates risk?

Consider a benchmark index like S&P 500. This Index has given n average annual returns of approximately 10% since inception 1920s. This does not mean all the companies have performed well throughout 90 years. There will be winners and losers. Moreover, winning and losing streaks of most companies occur in patches. Assume an investor who started during 1928 has beaten the average returns of S&P 500. To achieve the feet, he should have rebalanced and optimized his portfolios frequently. He would have spent a lot of time learning and gathering information on individual stocks of companies. Moreover, to win in such a complex game, an element of luck is essential. However, an in-depth (and time-consuming) analysis to pick winners frequently is not possible for an average investor.

If you are just a beginner you will have important things to do in life other than reading balance sheets of hundreds of companies. If that is the case, diversification is your best bet to avoid risks and achieve good and reasonable returns. The reason is an investor who invested in all of the companies in S&P 500 in the same proportion as the index would have gained 10% annual returns. Along with the power of compounding (provided he reinvests his dividends) he would have performed far better than a majority of other investors. Without much effort, he would have beaten those who spend a lot of time before stock tickers and price movements. Picking individual winners in the stock market is a dangerous game if you are not ready to invest your time and knowledge. Even if you don’t have the time to learn and analyze individual Investments, having a diversified portfolio will give you better returns than CDs and most bonds.

Let there be an index fund the tracks S&P 500. Assume you have invested the fund. Later you have forgotten to even check the progress for the next 10 years. Still, you have a minimum guarantee that if the US economy is going to perform well you will get good returns. Even if there was some recession in between, a benchmark as diverse as S&P 500 will recover as quickly as possible. In other words, if you trust your economy as a whole, you will never fail. This condition may not apply to an investor from an economically weak country. But for progressive or developed economies, the performance of broad benchmark indexes (and tracking funds) should be very reliable.

In short, diversification works like this. If X number of stocks fail then there will be Y number of stocks that rise so that X and Y combined perform well. Even in case of recessions, there will be some gainers that will balance price falls to some extent.

The bottom line is this. If you have limited time to analyze stocks, diversification should be an obvious choice. And diversification through index funds is better than traditional mutual funds as you saw in the beginning section of this post.

3 Exposure to Systematic Risk Alone

Before going further into risk related advantages of index funds, you have to understand two broad types of risks in financial instruments like stocks or mutual funds. The two types we are about to discuss are systematic and unsystematic risks.

First, let us discuss unsystematic risk. Assume you have invested in shares of XYZ company. Let the company be performing well for the past 5 years. The performance has motivated you to invest more and more into the same company in an expectation of higher yield or higher capital gain. Let the success of the company be primarily dependent upon a genius CEO. Let’s say after 5 years a crisis brews within the board so that the CEO of the company quits. Now you know what happens. A most probable scenario is a fall in the stock prices. Let the company belong to the tech sector. A risk like this will affect just the company XYZ but will not have any bearing on the other tech companies. In fact, some people will pull out the money from XYZ and reinvest in other technology companies. Thus there is a possibility of other companies benefiting from the crisis of XYZ. A risk like CEO stepping down is unsystematic. Such risks will not affect a sector or a benchmark as a whole. Instead, the risk will be felt only at the individual company level.

The other type of risk is a systematic risk. For example. Let there be a crisis regarding the use of the internet. Let some global regulations restrict the use of Internet after a user has browsed for a specific duration. Or let there be restrictions placed on the websites by powerful governments. In such a case the stock prices of the entire tech sector companies may fall.

Another example of systematic risk is the one faced by airline industry where the stock prices are affected by oil prices. For example, if oil prices rise an airline has no other way to sustain profits other than rising the ticket prices. Or if the ticket prices are maintained, the margins of the companies will be hurt. In either case, the profits of the companies will be affected to an extent that the price fall of stocks will be felt across the industry. Such types of risks are called systematic risks.

There is not much we can do about systematic risk. They happen always. However you can control your exposure to unsystematic risk if you diversify your portfolio. Diversification as simple as investing in broad benchmark index funds will help you overcome unsystematic risks.

As a point of note, investments like narrow index-tracking funds are exposed to both systematic and unsystematic risks. But well diversified broad index funds are exposed only to systematic risks.

4 Exposure to large number of assets

Not everyone is Warren Buffet. Not everyone has billions of dollars to invest. But many will be willing invest in a broad range of companies or commodities. But the amount in hand may be a limiting factor to invest in a large number of assets. For example, if your investment size is thousand dollars per month, you will not be able to buy hundreds of companies individually. However, index funds offer the benefit of scale. As a point of note, this benefit is not only specific to the index funds but apply to other types of pooled investments like active mutual funds.

For example, assume you buy a single share of an S&P 500 tracking fund for just $100. Still, your investment will be exposed to all large 500 US companies!

5 Tight Bid-Ask Spread

Bid Price

Before reading further you should know what is a bid-ask spread. For every asset like stock sold or bought in an open market, there will be a price that seller will be willing to sell. Also, there will be a price at which a buyer will be willing to pay.

For example, think about an imaginary company XYZ. Assume there are 100 shares issued in the open market. Let there be a seller who is willing to sell 5 stocks at $21 per share. This price is called the “ask price”. However a buyer may be willing to close order for $20 per share. This price is called the “bid price”. The difference between the asking price and the bid price is $1 which constitutes bid-ask spread. You should remember that there will be multiple numbers of sellers and buyers for the same stock at the same instance of time. When the number of stocks traded is high the bid-ask spread will be “tight’. This means buyers will be able to buy stocks at a comfortable price around their bid price. And sellers will be able to sell the stocks at a reasonable price close to their ask price. Assume a stock where the volume of activity is very less. In such cases, a seller will not be able to find an ideal buyer around their ask price. In such cases, the bid-ask spread will be “spread” (big difference between the bid and ask price).

As a general rule, tighter bid-ask spreads are a win-win situation for both the buyers and the sellers. In individual stocks or other individual asset investments, a tiger bid-ask spread is not guaranteed. There will be some stocks with high trading volumes and tight bid-ask spreads. There may be some other companies where buyers and sellers are finding it harder to achieve their price targets.

Now let us discuss how bid-ask spread fares in the case of index funds. You know there are two types of index funds. One is a mutual fund and the other is an ETF that tracks an index. In the case of mutual funds, there is no open trading. The price will be decided only at the day close. The very fact that there is no open trading eliminates the existence of bid-ask spread in the open market. Hence there is no problem if the volume (supply-demand) is low or high.

Now let us discuss index ETFs. In index ETFs, if the demand outpaces the supply, additional shares will be swiftly created by authorized participants (AP). This act of creation of additional units will help to bridge the gap between supply and demand. This process in effect decreases the magnitude of bid-ask spreads. Similarly, if more people are willing to sell ETF shares compared to the number of buyers, an authorized participant will redeem the shares with the fund provider. In either case, the bid-ask spread will be very tight compared to individual financial instruments like stocks.

Conclusion: Decide Yourself if Index Fund Investments are Good for You

Hopefully, the above points will help you judge if index funds are good investments. Decide for yourself based on you learned from this post or other sources. Take care that your decision aligns with your philosophy. The other factors which will influence your decision are your time, money and risk tolerance.

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