Index funds can be confusing.
There are 1000’s indices. Some are diversified; some are not. Then there are index mutual funds and index ETFs.
Over the last eight years of investing, I moved from individual stocks to a portfolio of total market index funds.
Index investing is where you hold all stocks in the stock market. More specifically, this is called “total market” index investing.
This decision has increased my returns and saved time (that I now allocate 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 Not So Fun Disclaimer
Any securities mentioned in this post are for educational purposes. I am not recommending these investments. Before making investment decisions, you need to know if you are ready to invest and what your risk tolerance is.
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 unique 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.
It’s also great if you are not ready to invest, but are taking action to get there.
Table of Contents
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. Some funds like VCN exclude tiny stocks.
- 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.
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Index Characteristics
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"
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.
Stock Size is Pareto Distributed
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 Distributed outcome.
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 matter regarding your usable wealth.
You can find inflation-adjusted returns by subtracting 2.7% 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
I’ll give a quick overview of the Canadian indices. But for more detail, read the Power of Reinvested S&P/TSX Composite dividends.
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:
- The FTSE Global All Cap Index, tracked by VT
- The MCSI All Country World Index, tracked by ACWI
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.
These fund distributions are taxed unless the index fund is held in a tax-sheltered account. To learn more, read my guide on taxes on investment income for Canadians.
How do You Invest in an Index Fund?
I’ll cover two types of index funds:
- The index exchange-traded fund (ETF)
- 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 buy and sell securities that trade on the exchange. ETFs are “Exchange Traded” funds, so 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.
Unlike the US, there are not many index mutual funds in Canada. I’m only aware of TD’s E-Series Funds.
Check out this article to learn more about the differences between mutual funds and ETFs.
Index Funds: Passive Vs. Active
Not all index funds are passive and not all index funds are diverse. 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.
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.
Active Exchange Traded Funds
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 All Index Funds Are Passive (or Diverse)
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.
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 sold and another stock has to be found to replace it.
The more complex the rules, the more “active” the fund. So a dividend growth index fund like VIG ends up being quite active, even though it tracks an index 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 – just include all stocks that trade in a market.
Why Index Funds Have Low Fees
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.
Other Points On Index Funds
Welcome to the random point section. This is where I place ideas that I failed to categorize above.
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.
Dollar Cost Averaging With Index Funds
Dollar Cost Averaging (DCA) is when you invest a set amount at a pre-determined frequency.
DCA naturally occurs when you save your income and periodically invest.
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.
For more specifics, you can check out the past 30 years of Market Returns: Top Pains and Gains. Or you can just visit Portfolio Visualizer.com
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.
Conclusion
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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Jake out.