Index funds can be confusing. This post will clear that up.
There are 1000’s indices. Some are “active”, and some are “passive”. Then there are index mutual funds and index ETFs.
Plus, what’s the benefit of index investing? Why not just pick individual stocks, or just invest in mutual funds?
I’ve worked through these questions over the last 7 years of investing.
During this time, I migrated from individual stocks to a portfolio of total market index funds.
This decision has increased my returns and saved time that I now devote to this blog.
By the end of this post, I want you to walk away with everything you need to know about stock (equity) index funds. This way, you can make informed investing decisions.
The Very Fun Disclaimer
Even a globally diverse portfolio of stocks can incur losses in excess of 50%.
Since 1900, a globally diverse portfolio of stocks has grown at 8% annually (source). Along the way, there were many crashes, wars, and pandemics.
Are You Ready To Invest?
Before investing, make sure you are ready to invest. Here is what that looks like:
- You have no consumer debt.
- A fully funded emergency fund exists, held as cash.
- You understand your risk tolerance.
To understand why debt paydown is important before investing, I point you to this post on Debt Paydown vs. Invest.
If you are ready to invest. You should be very proud. You are doing great financially.
You should also be proud if you are not ready to invest, but are taking action to get there. In this case, it’s great to learn about index funds to posture yourself for success.
Table of Contents
The 4 Key Concepts That Back (Total Market) Index Investing
Before I dig deep into index investing, I want to outline data and concepts that set the stage for index investing.
“But Jake, how do you define index investing”?
I define index investing as an approach where you hold all stocks on a stock market. More specifically, this is called “total market” index investing.
1. Most Mutual Funds Underperform "The Market"
You may be wondering, “why not invest in actively managed mutual funds, where professional stock pickers can invest my money”?
Although mutual funds are easy to invest in, over 80% of them fail to beat the market index after fees.
So, why not just pick the 20% of funds that beat the market?
Fund performance doesn’t persist, unfortunately. Past fund performance has almost no low correlation with future performance. I outline the outcomes of SPIVAs research below.
Also, fund manager skill and after-fee fund performance are different things. This it’s non-intuitive. My point is that it’s unfair to say that fund managers are not skilled.
Fund managers can be skilled, but the in investor in the fund (you) doesn’t benefit.
Instead, skilled managers attract fund inflows. The beneficiary of the skilled manager is the mutual fund company. More inflows allow them to skim off a greater dollar value in fees.
The end result is that picking actively managed funds as an individual investor is a losing game.
2. A Small Number of Stocks Make Up All The Returns
A tiny number of stocks are responsible for nearly all of the market’s returns.
For example, this study finds that “the top-performing 1.3% of global firms account for the $US 44.7 trillion in global stock market wealth creation from 1990 to 2018”.
If you miss out on this 1.3% of stocks, you will fail to beat the market.
You may ask, “why not just invest in the 1.3% of stocks that produce all the wealth? That seems easy.”
The 1.3% of stocks are easy to identify in hindsight. But the key is to find these companies before they explode in value. For more, see hindsight bias.
You can see that TSLA was one of these stocks that contributed heavily to the total market return between 2020 and 2022.
But I don’t know what will happen with TSLA moving forward. Neither do you. Nor does anyone else.
An investor can only expect the market return out of TSLA in the future because expectations about future earnings are already priced into TSLA’s stock.
It’s very likely that a new set of stocks (1.3%) will pull the market forward in the future.
Holding all stocks in a stock market is the only way to guarantee you will capture the returns of the next 1.3% of businesses that produce all the market’s wealth.
I will turn to the efficient market hypothesis to show why it’s hard to forecast what stocks will explode ahead of time.
3. Efficient Market Hypothisis (EMH)
The Efficient Market Hypothesis (EMH) states that all available information about a business is already baked into a stock’s price.
Millions of very smart people are conducting analyses to buy and sell stocks based on available information. This produces an equilibrium market price.
If all information is included in the stock price, then no amount of analysis can provide an advantage over “the market”.
In a perfectly efficient market, luck is the only way to beat the market.
But markets are not perfectly efficient, however, I believe they are efficient enough that it’s not worth my time to try to beat the market.
It’s hard to outwit millions of people who are buying and selling in response to new information. This result naturally results in owning the entire market.
For more, I refer you to this post on Efficient Markets.
4. Diversification Is The Only Free Lunch
Investors are compensated to take on investment risk. The compensation comes in the form of long-run stock returns.
But there is one catch.
The market only compensates you to take on risk that cannot be easily diversified away.
This is a core component of the Capital Asset Pricing Model. I‘m not sure about you, but I don’t enjoy taking risks that I don’t get paid for.
So what risks can be easily diversified away?
With a click of a button, a low-cost index fund allows you to own nearly every stock around the globe. By clicking your mouse, the following risks are diversified away:
- Company specific risk.
- Industry specific risk.
- Country-specific risk.
Therefore, you do not get paid for taking on risk associated with owning an individual stock. Nor do you get compensated for owning stocks in a specific sector, like tech.
When you own all stocks in a stock market, it doesn’t matter if a single stock crashes. The drop will be balanced out by hundreds or thousands of other stocks that remain afloat.
For example, assume TSLA goes to zero tomorrow. The S&P 500 index would lose around 1.7% with all else held constant. Diversification protected you from downside risk.
I discuss the concept of diversification in more depth in my post Intro To Investment Risk and Risk Tolerance.
So, how do you limit uncompensated risks?
Owning all stocks around the world will minimize the risks that you don’t get paid for. This leaves behind the compensated risks, also known as systematic risk.
What is an Index?
An index is a standardized collection of stocks or bonds.
At the heart of each index is a set of rules that define what stocks can be included. For example, the S&P500 includes the 500 largest businesses (stocks) in the US. In addition, these businesses must be profitable. Those are the S&P500’s rules.
There are thousands of indices out there, each with unique rules. This can make index investing very confusing.
To solve this, I will focus on total market index funds. They have the most simple rules.
Total Market Index
A total market index just holds all stocks in a stock market. For example, the US Total Market Index holds all US Stocks.
The rules for inclusion are simple:
- Hold all stocks in a stock market.
- Ensure each stock is held in proportion to its size.
Holding all stocks maximizes diversification. In addition, total market indices are very very simple. They are the most “passive” form of index investing.
I hope this solves most of the confusion around index types. Now, let’s look at index characteristics and common indices in the US and Canada.
The Index Acts As Benchmark
You may have heard someone say “I beat the market this year” or “Joe underperformed the market last year”.
These people are referencing an index as the benchmark. The index is used as a reference point.
Professional fund managers and individuals strive (and regularly fail) to beat the benchmark.
Common reference indices are the S&P500 Index, and the Dow Jones Industrial Average (“the dow”). In Canada, the S&P/TSX Composite is a common benchmark.
I’ll cover some of these common benchmarks below.
Indexes Are "Cap Weighted" and Stocks Are Pareto Distributed
The inequality in an index is massive.
For example, at the time of writing, 27% of the S&P500’s wealth is concentrated in the largest 10 stocks in December 2022. For every $1,000 invested in the S&P500, $270 goes into these giant stocks.
Almost all indices are capitalization weighted. This fancy dancy term means some companies make up a larger fraction of an index than smaller companies.
It is normal for a small number of companies to make up the majority of an index’s weighting.
Here you can see the unequal size distribution of the top 10 stocks in the US market as of December 2022.
As a quick sidebar, this type of unequal outcome is not specific to stocks.
Unequal distributions occur in the population of cities, the sizes of lakes, and even with traffic on this blog.
What do these seemingly different systems have in common?
All of these systems (stock, lakes, planets, blog posts ect) grow exponentially, producing a Pareto Distribution. This unequal outcome is named after an Italian dude who was curious about wealth inequality.
The Pareto distribution is also the foundation of the popular 80/20 rule, showing that 20% of your tasks produce 80% of your outcomes.
I think this is fascinating, so I wrote a post about it: The Pareto Distribution: Use It To Leave A Mark On The World.
Common Indices: With Historical Returns
Now I’ll cover big indices in the US in Canada, including historical returns. I’ll also cover a few total market indices below.
All index returns I show include reinvested dividends and are not inflation-adjusted. Note that U.S. dollar inflation has averaged 2.57% for the last 100 years (source).
I like inflation-adjusted returns because they are what matters when it comes to your usable wealth. You can find inflation-adjusted returns by subtracting 2.6% from the nominal returns I provide below for each index.
S&P 500 Index
The Standards and Poors (S&P) 500 index consists of 500 large and profitable U.S. businesses. These stocks are selected to represent the U.S economy across all 11 sectors.
An S&P500 represents a whopping 80% of the total U.S. stock market in market capitalization (source). Therefore, the S&P500 will mimic the US total market index very closely.
The index (sort of) began in 1926 and originally consisted of 50 stocks. It was formally founded and named the S&P500 in 1957. The average CAGR since 1923 has been ~10% annually, including all crashes in that time frame (source).
You can check out my post on The Power of Reinvested S&P500 dividends to see more about S&P500 returns, including the effect of dividends.
The Dow Jones Industrial Average (DJIA)
The “Dow” is composed of 30 large U.S. companies across various sectors of the economy.
Formed in 1986, it is the second oldest U.S. Index. Similar to the S&P500, the Dow has had a CAGR of 10.5% over the last century (source).
Although the DJIA only holds 30 stocks, it represents 22% of the total U.S. stock market. The DJIA is odd in that it’s price weighted, unlike most other capitalization-weighted indexes.
Overall, the DOW is not a very diverse index. It doesn’t replicate the Total US Market as closely as the S&P500.
US Total Market Index
The US total market index is exactly as it sounds.
It holds all stocks in the U.S. stock market, including tiny companies that are not captured by the S&P 500.
It has around 4000 stocks and has returned 10% per year over the last 122 years (1900 – 2022), or 6.7% per year after inflation (source).
A total market index fund such as VTI holds all the stocks that make up the U.S. stock market.
Since a total market holds all US stocks, it also holds all stocks in the S&P500 and DJIA. Put another way the S&P500 is just a subset of the US Total Market.
Common Canadian Indexes
The S&P/TSX 60 Index
The S&P/TSX 60 index holds the largest 60 Canadian companies. These companies are part of the S&P/TSX composite index.
This index is tracked by the world’s oldest ETF – IShares (XIU), established in 1998. Go Canada.
S&P/TSX Composite Index
The S&P/TSX Composite Index is a total market index for Canada. This index has the ~220 stocks that trade on the Toronto Stock Exchange (TSE).
The S&P/TSX Composite index is a total market index since it represents the entire Canadian Stock Market.
In addition, the index is a common Canadian benchmark that we use while discussing investing performance over a game of hockey.
Over the past 50 years, the S&P/TSX Composite Index has provided a CAGR of 9.1% (source).
I invest in the stocks that make up this index by using the ETF VCN.
Global Total Market Indices
There are also indices that track nearly all stocks in the global stock market.
Here are the big four indices that cover the global stock market. You can click each link to learn more about each index.
- The MSCI EAFE Index (International Stocks)
- The US Total Market Index
- The S&P/TSX Composite Index (Canadian Total Market)
- MSCI Emerging Markets Index
Index funds that track these indices give you the ability to own thousands of stocks around the world at a low cost.
Alternatively, there are global total market indices. These guys are the mother of all indices. The two main global total market indices are:
I’m sure you are tired of hearing about individual indices by this point. Hang in there, now I will dig into the ways that you can invest in such indices.
How An Index Fund Works: Mechanics of an Index Fund
Now you understand what an index is. But how do you actually invest in that index?
To own the index, you must own all the stocks on that index in the right proportions.
Here is a useful thought experiment to show the value of an index fund. It will also show you how an index fund works. Consider how you might replicate an index on your own.
Let’s use the S&P500 index. To replicate the S&P 500 index, you would need to execute the following steps:
- Purchase 500 separate stocks through your brokerage, in proportion to their weightings on the S&P500 index.
- When you have additional cash to invest, you would need to buy all 500 stocks again in 500 separate transactions.
- Sometimes stocks get replaced on the index because they no longer meet the S&P500 index criteria. You would need to monitor the index, and buy/sell to accurately track the index.
Clearly, this is time-consuming and impractical. Plus, it would be super expensive for those without a zero-commission brokerage.
An index fund solves this problem.
An Index Funds Pools Funds
An index fund pools money from various investors to provide economies of scale.
For example, the index fund SPY manages $378 billion. SPY’s fund manager then uses investor funds to purchase the 500 stocks on the index with the proper weightings. Now the fund naturally tracks the index.
When you invest in this fund, you own a small portion of each of the 500 stocks that make up the S&P500. By owning these stocks, you get to share in the returns that these businesses generate through earnings growth and dividends.
Index Fund Dividends And Distributions
Dividends make up a meaningful chunk of stock returns.
You may wonder, “how do these dividends end up in my pocket when I own an index fund?”
Dividends from the individual stocks accumulate in the fund. Then the fund distributes these dividends to you at set intervals. Usually, they are distributed every 3 months (quarterly).
These fund distributions can be automatically reinvested in new shares of index ETFs if your brokerage allows. This can is called a dividend reinvestment program (DRIP). For more, read How To Use DRIP With Canadian Index ETFs.
Unless the index fund is held in a tax-sheltered account, these fund distributions are taxed. For my fellow Canadians, you can read my guide on taxes on investment income to learn more.
How Does One Invest In An Index Fund?
I’ll cover two types of index funds:
- (1) The index exchange-traded fund (ETF)
- (2) The index mutual fund.
So, what’s the difference?
An ETF trades on an exchange. Just like an individual stock, you can see minute-to-minute variations in the price of the ETF throughout the trading day.
Unlike an ETF, a mutual fund does not trade on an exchange. Instead, the mutual fund’s value is updated at the end of each trading day.
At the end of the day, index ETFs and index mutual funds both track your index of choice. They both accomplish the same goal.
How To Invest In An Index With Exchange Traded Funds
Since the ETF trades on an exchange, you must buy ETFs through an online discount brokerage.
Your brokerage is the middleman that between you and the exchange. It allows you to trade on the exchange. ETFs are literally “Exchange Traded” funds. They trade on a stock exchange.
On your online brokerage, you can select the number of ETF shares you want to buy, and then you can execute the trade. Then you hold the ETF and let it sit for the decades ahead.
This is a very brief outline, and I know this can be intimidating. There is lots of content out there to help you conduct this task at your specific brokerage.
Additional resources for Canadians on how to invest in total index funds include:
How To Invest In An Index With A Mutual Fund
Mutual funds can also be bought through your brokerage. But unlike ETFs, mutual funds can be bought directly from the company that manages the mutual fund.
With a mutual fund, you don’t see the price movements during the trading day. You only see the mutual fund’s price at the end of each trading day. That’s one data point per day.
This is fine because the movements of an index during the day don’t matter anyway. In fact, the lack of intra-day info is a good thing. It helps to reduce behavioral errors when investing by smoothing volatility.
Other differences between the index mutual and the index ETF is that mutual funds don’t charge commission fees to buy and sell. Finally, contributions to index mutual funds are easy to automate relative to index ETFs.
There are not many index mutual funds in Canada. I’m only aware of TD’s E-Series Funds. There are way more index mutual fund options in the US.
Check out this article to learn more about the differences between mutual funds and ETFs.
Index Funds: Passive Vs. Active
Not all mutual funds are active and not all ETFs are passive. I remember this was confusing to me, so I’ll briefly cover the difference between “active” and “passive” funds.
First, there is a spectrum between passive vs active. It is not black and white, even though it’s often portrayed that way.
This is partly because “passive investing” is a buzzword. Another reason is that it’s easier on our human brains to categorize things as black and white.
An active fund is one that “actively” seeks out specific stocks to generate a market-beating return.
An ETF like ARKK is actively managed. The fund manager is using their judgment to “actively” find individual stocks in hopes of beating the market.
These active funds, generally have higher fees. Someone has to work hard to pick these stocks and monitor the portfolio.
Whereas a mutual fund like VTSAX is very passive. It tracks the total US market and therefore owns all stocks in the US market.
Not Every Index Is Passive
Since an index is just a set of rules, the intensity of those rules drives how often stocks drop off/on the index.
In turn, this drives how much buying/selling the fund manager has to do to track that index. This is called turnover.
Even the S&P500 has a very small “active” component since stocks must meet rules related to size and profitability. When a stock no longer meets these rules, it has to be bought and another stock has to be found to replace it that meets the criteria.
The more complex the rules, the more “active” the fund. So a dividend growth index fund like VIG ends up being quite active, even through it tracks an index. The index in this case is the S&P U.S. Dividend Growers Index.
The Truly Passive Approach
The only 100% passive investing approach is a total market index fund. The reason is that the rules for inclusion are of maximum simplicity.
Top 3 Benefits Of Index Funds
There are many benefits of investing in index funds. This post is getting long, so I’ll only cover the top 3. They are listed in order of awesomeness.
1. Index Funds Save Time and Energy
There are endless demands on your time and energy. Life is hard.
Low-cost total market index funds help here. They are simple. And simple investing solutions help you grow wealth sustainably, as I cover in this post.
Less time spent on investing frees up time and energy that can be allocated to other things that enhance your well-being.
Index funds let your money compound in the background while you focus on the important things in life.
Finally, placing value on your time and energy naturally incentivizes frugal living. For more tips in this domain, see:
Stock Selection Efforts Drain Your Time
Building a portfolio of individual stocks is a ton of work.
Reading balance sheets and income statements, and understanding industry trends and competition.
Then you have to understand how the company makes money, and how it maintains a competitive advantage.
That is a lot of work.
Individual stocks work for some people, and that’s great.
To make a good decision here, I recommend that you put a dollar value on your time.
Then you can estimate what returns you would need to get in excess of the market to compensate yourself fairly.
2. Index Returns = Guaranteed Market Returns*
With a total market index fund, you will receive the market return, minus a small fee equal to the MER. This fee is normally around 0.03% to 0.2%.
With such low fees, you get to capture the wealth created by businesses while minimizing the wealth stripped off by the financial services industry.
Index funds keep you as close as possible to the wealth-generating businesses.
3. Index Funds Have Low Fees
You can expect the entire group of funds to get the market return in aggregate. Therefore, you can expect funds to underperform the market by an amount equal to the fund fee.
Why Are Index Fund Fees Low
Mutual funds and exchange-traded funds do not manage themselves.
They have operating and administrative costs that must be covered by someone. You help to cover a fund’s costs through the Management Expense Ratio (MER).
The MER is expressed as an annual percentage of the amount invested. For example, you are paying $100 per year in fees if you invest $10,000 into a fund with a 1% MER.
Large funds are better able to leverage economies of scale because they have a larger pool of investors who can cover the fixed overhead cost.
Index funds also have low management efforts because the rules for the inclusion of stocks are very simple. The MERs for passive funds typically range from 0.03% to 0.3% per year, versus 1% to 2.5% for actively managed funds.
How Fund Fees Impact Long Term Wealth
A 1% MERs may seem small, but it makes a huge difference in the end-wealth over the long term.
Two key factors drive the impact of MERs: the fee directly paid and the forgone compound growth of paying those fees.
I cover how fund fees impact your end wealth in detail in my post Fund Fees: How They Hurt You Financially.
Other Points On Index Funds
Welcome to the random point section. This is where I place ideas that I failed to categorize above.
Dollar Cost Averaging With Index Funds
Dollar Cost Averaging (DCA), where a set amount is invested at a pre-determined frequency.
Common frequencies are every paycheck, monthly, quarterly, or annually.
I accumulate savings and invest every two months. I stick with this system regardless of what the market is doing.
But doesn’t DCA prevent market timing?
DCA 100% ignores market timing. This is good for a few reasons:
- You can’t time the market, nor can anyone else. This fact is backed by the Efficient Market Hypothesis (EMH) and Random Walk Theory.
- DCA prevents you from trying to time the market. It is a system that enables you to focus on other things in life.
- Investing at set frequencies can be automated in some cases for a completely hands-off approach.
- You will naturally hit the highs and lows of the index, reducing volatility.
- DCA keeps your emotions out of the picture. Systems like DCA protect you from yourself.
Lump Sum vs. DCA
Above, I talk about investing in savings for the long term as soon as the money becomes available.
There is another form of DCA relating to large sums of money, like an inheritance. Under this form of DCA, the lump sum is broken up into smaller investments in the future.
In such a case, investing in a lump sum immediately results in a better-expected outcome relative to DCA. This is because it maximizes time in the market.
You can learn more about DCA vs Lump sum investing in this Vanguard Article.
Index Funds, Crashes And Risk Tolerance
Although stock index funds dampen the volatility of individual stocks and sectors, you still must be prepared for large crashes.
Recessions happen, bubbles happen and global uncertainty happens (COVID).
A quick look at the history of the S&P500 or the global market will show you multiple 50% or larger crashes.
I believe you should not invest in a 100% stock portfolio unless you are:
- Emotionally ready and willing to remain invested through a 60% crash.
- Can remain invested for at least 10 years.
You may not meet those criteria, and that’s okay. There are ways to reduce portfolio risk through the addition of bonds. See more about the role of bonds in a portfolio in this post.
What about short-term savings, like less than 5 years?
Stocks are not the answer here.
There are other assets useful for short-term savings. These include money market funds, short-term bonds, HISAs, and GICs.
The Best Books On Index Investing
The two books that taught me the most about index investing are:
For those who want to learn about individual stocks, a great book is One Up On Wall Street by Peter Lynch. This book teaches you about the efforts involved in picking individual stocks and the mindset required. It’s also entertaining, with lots of dry humor.
Total market index funds offer a simple hands-off approach to investing.
They allow you to hold a basket of stocks that make up the market. By their very nature, you will receive the market return, minus the tiny fees.
Not only do total market index funds save time, but they also beat the vast majority of actively managed funds.
Furthermore, Index funds optimize long-term risk/reward trade by eliminating the risk that you do not get compensation for.
I hope this provides you with a solid understanding of stock indexes, index funds, fund fees, and diversification.
I personally grow wealth slowly with index funds. I’m not smart enough to beat the market. Plus, my energy and time are better spent on fitness, family, career, and this blog.
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