Indexing investing or investing in an index fund is one of the most efficient and cost effective means of compounding capital over the long term.
An index fund is a commingled pool of capital dedicated to track the performance of a particular market, industry, commodity or asset class.
The risks of index funds varies depending on the market exposure. The degree of risk in index investing can be managed via portfolio allocation between the index fund where for example a greater weighting can be had for lower risks index funds to create a conservative portfolio or vice versa.
Top 3 benefits of index funds over active management includes:
- Lower cost
- Intraday liquidity which allows investors to enter and exit the investment at anytime
- Option to diversify the portfolio. There are so many ETFs that tracks every conceivable asset class or market. Active management is best for most common or largest asset classes.
Research has shown that over the long run, active funds has underperformed the passive index funds. This is also reflected in the growth of passive fund AUM where it is taking majority of US equity inflows at the expense of actively managed funds.
Index Funds vs Exchange Traded Funds
There are multiple ways for investors to invest in an index fund. Index funds are also commonly referred to as Exchange Traded Fund (ETF). The difference between these funds are exchange traded funds are index funds listed and traded on a stock exchange. Index funds on the other hand are unlisted funds which means the process for investors buy in or selling out of the funds will be at least on a daily basis rather intra day when the markets are open.
Most Common Type of Index Funds – Passive Index Investing
One of the most well known index fund is the SPDR S&P 500 (SPY) which tracks the S&P 500, the most quoted market benchmark in the world. Recently NASDAQ is making a good run for the same title (QQQQ tracks the Nasdaq index) .
Passive index funds implies once the sole responsibility of the fund is to track the performance of a particular market index. The portfolio manager does not have any active input in the investment process in stock selection or portfolio weighting of the positions.
Exchange Traded Funds (ETF) are index funds listed on the stock market as opposed being unlisted index funds. This means that once the decision is made to replicate a particular index fund, the fund manager does not have any active input in the selecting the stocks going in to portfolio.
Stock selection in a passive fund is determined based on a pre-set of rules outlined by the the index provider (such as MSCI or Standard and Poor’s).
Some other examples of investments which are tracked by indexes includes:
1. Asset class indexes such as fixed income, REITs or commodities
2. Country funds which tracks the benchmark of other countries like UK, Germany, France.
3. A subset of this are emerging market funds which has a natural higher degree of risk like Russia or India but should be compensated by higher growth and return over time.
4. Sector exposures which replicate the performance of companies in a particular industry like housing, financials or health care.
Factor Investing
The latest trend in index investing is a variation called factor investing where a the fund is designed to track a specific type of fundamental factor such as fundamental (book value, growth or momentum).
Aside from fundamental factors, factor funds can also shift portfolio weights.
Index fund portfolio allocate a percentage to a stock based on the company’s size relative to the rest of the market. This means as the market cap increases, the stock’s weight in the portfolio also increase. Equal weight funds invests with a fixed weight allocation across all of the position in the portfolio.