Investing 101: What is an Index Fund?
You can “invest” in just about anything. You can buy an artwork and if you buy it because of its potential future value (gains) you can make on it, that art is an investment.
One of the most basic investment options you have in to purchase stock in a company. As share of stock a small piece of the company. The value of the stock is based on a lot of things, including how the company is performing, and what people who are buying the stock thing about the company’s future performance (much like how you would be betting on the artwork becoming more valuable over time.)
But putting all of your money into one artwork is super risky. Same goes for putting all of your money into one company. This is because even if that one company is doing incredibly well today, you don’t know how it will perform in the future. A competitor may come along and offer a better product. The industry may be completely disrupted–Blockbuster seemed like a sure thing when we were all going out to rent VHS tapes to watch on Friday night (am I dating myself?–but years later we know how that story ended up.
While it might sound like a good idea to invest in “stocks you know,” it is in your best interest to diversify. That is–buy small amounts of many company’s stocks. But to do this buying individual stock wouldn’t be scalable. Let’s say you want to buy shares of 500 companies, and ensure you have the same percent in each.
This is where index funds come in.
Index funds are basically a collection of many company stocks that make up a financial index. They are passively managed. This means that no human being (or robot) is deciding you should have more shares in one company because of its future performance potential. An index fund also has some strict rules around when it can be traded–you can only buy and sell for the price of the fund at the end of each trading day.
You may hear the term “ETF” used interchangeably with index funds. They are not the same. ETFs–exchange-traded funds–are a basket of securities you buy through a brokerage firm. There are many different kinds of ETFs. (There are index fund ETFs!) I’ll cover this later in another post (link coming soon.) Mutual funds are also related to index funds, and that will also be covered in a future post.
What is a financial index?
A financial index follows a bucket of companies. For example, the S&P 500 tracks the largest 500 public companies in America. NADSAQ follows top tech companies. There are approximately 5,000 US indexes alone — plenty for an investor to choose from. The basic idea is that if you want to invest in the overall health of the US economy, you are better investing in the S&P 500 index than 3 companies (i.e. you could buy Walmart, Apple, and Amazon stock, or you can buy 500 companies including these three companies.)
Investing in an index fund does NOT mean you will avoid losing money.
In the worst year of the history of the S&P 500, way back in 1931, it lost 38.1%. So if you bought $100 worth of S&P 500, you would have lost $38.1, if you sold the index fund when it was at its lowest point. However, if you invested in one company that went out of business the same year, you would have $0.
The best year of the S&P was 1954. It gained 53.6%. That means if you had $100 invested, you would have made $53.6 on top of your original $100 investment.
As you can see in the chart below and at the detailed table on this page, the S&P index had a few bad years. But if you didn’t sell out, the index returned to its highs. For example, if you invested in $100 in 1930 right before the stock market crash and reinvested your dividends, in 1931 you would be down 34.37% (or $34.37). By 1935 you would have gained a lot of money back, and you would be down by just 10.25% (or $10.25.) By 1940, you would be at almost break even.
Twenty years later, in 1950, you would have made an average of 4.42% a year. Even if you put your $100 in right before the stock market had its worst year ever. You would have $237.51 in 1950, based on that $100 you put in right before the stock market crashed, even though you lost almost half of it right away. (Play around with your own investment scenarios in this awesome online S&P 500 calculator.)
You will always hear past market performance is not predictive of future returns. This is very true. You cannot be certain that we won’t have a major war, or that our economy will remain relatively stable and in growth mode forever. BUT, there are a lot of very powerful people who will do whatever it takes to keep the overall economy going “up.” The government needs the economy to grow, so they will do things like printing money to make it happen. It would be highly unlikely every single one the top 500 US companies would go out of business, all at once. If that happens, we have much bigger problems as a country.
Investing in Index Funds is a Low Fee Investment Option (Yeay!)
Fees are the enemy of gains when it comes to your money. Unless you are buying individual stocks on an app like Robinhood or eTrade, you will be paying fees. Someone has to do the work of putting all the stocks together in a fund so you can purchase them.
For passive index funds, your fees will be very low–as low as .08% per year, or about 8 cents for every $100 you invest. Compare this to actively managed funds that might have a 1%-2.5%, or $1-$2.50 for every $100 invested fee. That may not sound like a lot, but when you have $100,000 invested, a 2.5% fee is $2500 a year! Look at the gross annual expenses for Invesco’s actively managed funds — even their S&P 500 fund has a .55% fee (ouch!)
It’s been proven time and again that even really smart investors cannot beat the market 100% of the time. They may get lucky, but over time index funds tend to outperform anyone who picks stocks.
NerdWallet analyzed a variety of scenarios and in one case found that paying just 1% in fees could cost a millennial more than $590,000 in sacrificed returns over 40 years of saving!!! (Read more here why fees suck.)
Just a quick fun calculation. Let’s take one of Invesco’s better performing funds — Invesco Oppenheimer Global Opportunities fund.
Here is the dude who manages your fund. Meet Frank. He has a PhD in economics from the University of Geneva Switzerland. Hi Frank.
Notice Frank’s slight smirk? That twinkle in his eye? That’s the look of a man who has a very nice house and a few luxury cars thanks to you thinking he can beat the market.
His high fee fund is outperforming most other funds at his firm. Here are the top companies in his fund today. 10% of the fund is in a company called Nektar Theraputics. It looks like they aren’t doing that well…
Nonetheless, Frank’s overall fund is doing pretty well.
- gain since inception in 1990 = 12%
- annual expense 1.09%
- max load: 5.5% (what you have to pay to purchase the shares–another fee!)
To compare to an index fund, let’s look at how this fund performed over the last 10 years.
Say you put $1000 into this fund in 2010. You pay $110 up front (5.5%) to buy the fund. So you are starting with $890 to invest. Then you earn 12.71% a year, but you are paying 1.09% a year, so your earnings are 11.62% per year. Not bad, right?
- $890 at 10.91% per year for 10 years = $2,671.84
- That’s a $1,671.84 gain on your investment. Not bad!
Let’s say you took that same $1000 and put it into a S&P fund during the same 10 year period, from 2010 to 2020. Your return would be 11.3% per year. Your fee is .10%, so you get 11.2% per year in gains.
- $1000 (no front load fee) at 11.2% per year for 10 years = $2891
- That’s $219.16 MORE than if Frank managed your money
$219.16 may not seem like a lot of money, but imagine you invested $100,000 with Frank vs $1000. You would be down $21,916 in that 10 year period. And this is compared to an actively managed fund that is performing well! Moral of stories — don’t fall into the trap of high fee funds that “beat” the market. It is very rare these funds outperform the market with their fees. More likely, they will underperform, and then be even more expensive due to the fees you pay to Frank. No offense, Frank.
(Check out the 10 year returns of other low-fee Vanguard funds here.)
Index Funds are NOT Perfect
Ideally, when you diversify to buy 500 stocks, you want the same amount of money in each company. So if you put $500 into an index fund, you’d want to buy $1 of each company. But that’s not how it works. The companies with the largest market caps (the biggest companies) will actually get more of your $500. For example, Apple would get $3.7, which means it would be impossible for every other company to get $1.
If Apple stock is going up a lot, this will make your index investment go up faster as well. But if Apple stock goes down, you’re going to be more exposed to this one stock versus having a true diversified fund. So having an index fund is much better than having $500 in Apple stock (if that’s your only investment) but it still isn’t truly diversified.
Also, if you genuinely think over time the US economy is going to self destruct, you might want to avoid index funds–at least US-based ones. You can invest in international index funds or index funds from other countries you think will outperform the US.
Generally speaking, large cap US stocks are relatively safe in the long term. This does not mean you will always gain money on the investment, but it does mean that it’s unlikely all US companies will go out of business on the same day. Remember, in our example above, in 20 years you were still making a profit on the original $100 you invested (above inflation), even though you lost a huge chunk of it up front.
In Summary
Index funds are a good option for investments when you want to diversify (i.e. buy stock in a lot of companies, not just a handful.) Your other options to diversify your investments are to buy hundreds of different stocks (very hard to manage) or purchase other diversified funds such as non-index-based ETFs or mutual funds (actively or passively managed.)
