Index funds are a cheap, easy, and well diversified way to invest in the market. We’ve previously looked at how investment fees work and one of the challenges is knowing when a high fund admin cost is in fact adding value or not. This is understandably a very difficult thing to assess. One option would be to ask your financial advisor to analyse your investments and do some nifty forecasting for you. Another option though is to just avoid high cost investments and look at the good old boring low cost, index-based investments. Let’s explore what index funds are all about.
Index Funds, the extremely boring chameleon of the finance world
Simplistically put, an index fund is nothing more than a fund (like a Unit Trust), that aims to replicate the performance of an underlying group of assets or index. An index is simply a moving tally that represents the movements in price of an underlying group of shares, or assets.
You might be familiar with terms like the Johannesburg Stock Exchange All Share Index, or the US S&P500. These are indices that track the general stock market in their respective countries. It’s a convenient way of seeing what the general stock market is up to; the average of all the companies in the selected index.
All indices are made up of certain shares, as its name would suggest, the S&P500 tracks the performance of 500 large companies in the United States. What an index fund will do, is to replicate the index, by buying all the shares in the underlying index (yes, all 500), and in the same proportion as they represent in the index. It’s a way of effectively owning the entire market, but investing in one simple fund.
The alternative would be if you went out and bought every single share in the index yourself. Not only would that take a lot of time, but it would be expensive and require you to make constant adjustments all the time, as the various components in the index changed.
Index funds; a single point of entry
Index funds gives you one point of entry into buying ‘the market’, through one simple investment fund.
As you’re no doubt realising, by owning the market via one fund, your returns will never be materially better or worse than the market – it cannot be. If all the underlying shares in the fund are exactly what would be in the market (as represented by the index), you’ll always get what the market gives.
But I don’t want what the market gives me – I don’t want average returns
Markets are unpredictable and trying to chase returns over what the market provides is largely a waste of time. You can obviously hit it big and find the “winning shares”, but then again you can lose a lot of money. Think of the big time companies on the stock exchange that have been riddled with fraud and corruption scandals. We don’t play the the market, we work it!
If you can appreciate that the market dictates your investment returns, and not any one person or strategy, then you’re doing well. Getting average returns is something to be proud of, especially when you’re not paying average fees – you’re paying less!
Why are they so cheap?
So how do investing and low cost index funds tie together? Simple:
Financial gurus make a lot of money
If the index fund you are investing in is not paying some very qualified people, some exorbitant salaries to try and provide excess returns for you, the costs of the fund will be low. If the fund costs are low, you won’t be charged that much.
This is called passive investing – ‘passive’ in the sense that there is no active strategy to try and outperform the market. By selecting those shares that constitute the index, you’re passively choosing to get what’s served to you by the market.
Active vs. Passive investing
This is likely the single biggest contentious issue within the financial services industry. As you can imagine, some very qualified people are charging a lot of money to investors, for the prospect of a higher return than what the market might give you. These active managers are unarguably very clever folk, however they’re not qualified to provide you with superior returns over the long term – nobody is, or can be.
A passive fund on the other hand, acknowledges on day one that it’ll never beat the market, so why pay people to try and do it for them? They hire very few people and a computer programme tells them what to buy and sell so that their index fund continues to mirror the underlying index.
Given that these passive fund costs are so low; your investment fees are low.
As a generalization, that passive fees when compared to active fees are typically half. In fact, sometimes even a quarter.
HALF?! You mean I could be paying double for some of my investments, than what I need to?
But hang on! How do I know that if I’m going to switch funds in search of less fees, that I’m still getting the same thing? Cheaper fees generally mean a cheaper product or service!
Good question: Remember how we told you that a passive index fund tracks the underlying index? Well, if two funds are both tracking the same index, or the same general pool of assets, you by definition, have to arrive at pretty much the same outcome.
What makes this whole active vs. passive debate even more ironic, is that the performance of a fund, is largely the one single attribute of a fund that is used to market it to folk out there. No fund that performed poorly last year, will boast on TV how as to how their fund performed 17th overall last year.
Would you invest in that?
You see, past performance should not and cannot be a proxy for future performance. It cannot be, as if a fund did well last year (and sometimes badly), the theory of efficient markets will say that its luck. Unless you believe in luck persisting (maybe you need a financial advisor sooner rather than later), then why would you choose someone simply because their coin landed on heads 12 times in a row?
Luck does not exist. Sorry
What we’re saying is a lot to take in – we get that. You have after all, just been told that you’ve likely been paying twice as much for all your investment fees since the day you started investing.
The best thing you can do going forward, is to be acutely aware of investment fees and costs whenever you invest any money. More and more financial services companies are offering lower cost investment funds, with some having built entire business models around passive investing.
Long term, you’re not going to beat the market, and you’re going to wear yourself down trying. It’s very possible to get great returns on an investment without ever having to explain a massive loss on the stock market to your family at some point. Don’t make gambles that a much older version of you might have to pay off.
Low cost, boring index funds that give you average returns may well over a 20-year period be better than an actively managed, high-cost investment. Especially when taking the fees into account!