Understand Index Funds: A Simple Way To Invest in Stocks

Jake - Author/Founder

Jake - Author/Founder

I'm Jake. I believe you can build a wealthy life through frugal living and index investing.

Better results with less work – sounds like a scam, right? Most extra value in your life comes from hard work.

But investing in stocks and bonds is different – simple solutions provide the best returns. One solution is to buy all the stocks in the stock market at low cost. An index fund does just that. 

It is important to understand your investments, even if you don’t manage them. No one cares about your money more than you do. 

The aim of this post is to help you understand how index funds work, including types of indices, historical returns, and comparison to traditional mutual fund performance. 

Why Should You Care About Index Funds?

I believe you should care about index funds once you are ready to invest. All high-interest debt has been paid down and you have an emergency fund.

Here is why you should care about index funds: 

  • Index Funds are simple, saving your time researching and selecting individual stocks. Your time has value. 
  • Index fund returns beat 87% of professional U.S. stock pickers over a 10 year period1. Canadian mutual funds performed even worse in Canada. 
  • Index funds minimize your investment risk through diversification.  
  • The simplicity of index funds reduces the likelihood that you will make behavioral errors based on your human biases. 
Four Reasons Why I Love Index Funds

Warning: Index Funds are Boring

Index funds are boring.

The excitement of researching and selecting good performers no longer exists.

The excitement you get from a stock that skyrockets 100% within one week? Non-existent.

Fear and panic from a stock that drops 50% in a week? Gone.

What is an Index?

An index is a standardized collection of stocks.

Stock indexes represent an entire market or a segment of the stock market. Thousands of such indices exist across the globe.

Most of these indices are noise. I’ll focus on the core indices in the U.S. and Canada. 

Indexes also exist for other securities such as BondsReal Estate Investment Trusts (REITs) and Commodities. However, I will maintain a focus on stocks in this article. 

Index Characteristics

The Index as a Benchmark

Most of us have heard people referencing “the market”. You may have heard someone say “I beat the market this year” or  “Joe underperformed the market last year”.

When people say “the market”, they are referring to a benchmark index that tracks the performance of a collection of stocks.

An index fund, therefore, represents the performance of a collection of businesses.

The S&P500 Index, the Dow Jones Industrial Average (the dow”) or the S&P/TSX Composite in Canada are common reference indices. 

The benchmark gives a reference point to measure portfolio performance. Professional fund managers and individuals strive (and regularly fail) to beat the benchmark.

The S&P500 index is a common benchmark used as a reference point for the performance of active funds and individual investor portfolios.

Indexes are Weighted

Most indices are capitalization weighted, meaning that large companies make up the majority of the index. 

For example, 27% of the S&P500 Index is made up of only 10 stocks. 

It is normal for a small number of companies to make up the majority of an index’s weighting, as most of the stock market capitalization is concentrated amongst few very large companies.

S&P500 Index Composition Pie Graph
S&P 500 Index Composition as of 04 Jan 2021.

On an interesting note, this inequality is similar to the natural distribution of wealth in a population. Or the distribution of workload across workers in an organization. Both follow the Power Law (or Pereto Distribution) quite closely.

Fun Fact: The Pereto Distribution is also the source of the popular 80/20 rule.

Common U.S. and Canadian Indices

U.S. Indices

The most common U.S benchmarks are the S&P500 and the Dow Jones Industrial Average (DJIA). Another common U.S. Index is the NASDAQ. I will not focus on the NASDAQ because it is a narrow index focused on technology stocks.

All index returns I show include reinvested dividends and are not inflation-adjusted. Note that the U.S. dollar inflation has averaged 2.57% for the last 100 years 2. You can simply subtract 2.57% from the return values for each index to arrive at inflation-adjusted returns.

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. The S&P500 represents a whopping 83% of the U.S. stock market in market capitalization3.

The index (sort of) began in 1926 and originally consisted of 50 stocks. It  was formally founded and named the S&P500 in 19573.  The average CAGR since 1923 has been 10.2% annually, including all crashes in that time frame (Great Depression)4.

This post on The Power of Reinvested S&P500 dividends to see the role of dividends on total returns. This is useful to understand dividend characteristics such as stability. 

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 5.

Although the DJIA only holds 30 stocks, it represents 21.5% of the total U.S stock market. The DJIA is odd in that it’s price weighed, unlike the most other capitalization weighted indexes.

Wilshire 5000 Total Market Index

The Wilshire 5000 is a total market index. It holds all the stocks in the U.S stock market. The index held 5000 companies when it was incepted in 1974. Now the Wilshire 5000 holds roughly 3500 stocks.

This index is a benchmark for the total U.S stock market and provides maximum diversification of U.S stocks. The return of the Wilshire 5000 is 11.4% since inception in 19746.

A total market index fund such as VTI or VUN allows you to own all the stocks that make up the U.S. stock market. I invest in total market index funds. 

Common Canadian Indexes

S&P/TSX Composite Index

The S&P/TSX Composite Index is a benchmark for Canadian stocks. This market-cap-weighted index holds 222 stocks that trade on the Toronto Stock Exchange (TSE). 

Over the past 50 years, the S&P/TSX Composite Index has provided a CAGR of 9.3%7.

I invest in the stocks that make up this index by using the index funds VCN

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. 

How Do I Invest in An Index?

You can invest an index through a passive exchange-traded fund (ETF) or a passive mutual fund. 

ETFs are “funds” that trade just like stocks on an “exchange”. You can buy ETFs through a brokerage by searching for its ticker symbol. 

Index ETFs that track the common U.S and Canadian indices are displayed to the right. 

 Do your own research before investing. This is not investment advice. 

A Chart of Common Index ETFs

The Mechanics of an Index Fund

You could technically replicate an index on your own by individually purchasing every single stock on that index. However, there are three problems. 

To replicate the S&P 500 index, you would need to:

  • Purchase 500 separate stocks, in proportion to their weightings on the S&P500 index. You would expend a huge chunk of your time and capital. In addition, brokerage fees would be high.
  • Update your portfolio whenever a stock drops off the index and is replaced. You would need to sell the stock that dropped off the index and buy the replacement stock. More of your time = gone. 
  • Any time you had additional cash to invest, you would need to buy all 500 stocks again in 500 separate transactions. Time= gone. 

I should be clear why this is not very smart.

An index fund makes this work without outrageous fees because of one thing – scale. 

An index fund pools money from various investors to provide economies of scale.

The fund manager then purchases every stock on that index with the proper weightings. 

Now the fund’s portfolio naturally mimics the index. 

All investors who invest in the fund indirectly own a small portion of each stock in the index.

Passive vs Active Management

Consider two fund managers: Sarah and Mike.

Sarah is “actively” researching and hand-selecting specific stocks, and Mike is “passively” looking at an index, and buying the stocks on that index in the correct proportions.

 Mike doesn’t need to read balance sheets. He doesn’t investigate competitors.

Index fund managers like Mike take a passive approach. They don’t make active attempts to diversify their portfolio. Further, they don’t need to figure out how much of their portfolio to put into each stock.

An active fund like the one managed by Sarah attempts to beat the market and parallels a typical mutual fund. The efforts of stock research, stock selection, and diversification come at a cost.

It is obvious to see that Mike is golfing while Sarah is putting in a ton of work, and she likely has a team. 

You need to pay mike less and that is why fees for index funds are far lower than those for mutual funds. 

Mutual Funds and The Exchange Traded Fund (ETF)

The main difference is that the “exchange” traded fund trades actively on an “exchange” like a stock and has its own ticker symbol. You can see minute-to-minute variations in the price of the ETF throughout the trading day just like a stock.

Both mutual funds and ETFs can be passively managed or actively managed. ETFs and mutual funds take money from a pool of investors and invest it for everyone.

A mutual fund does not trade on an exchange and the fund value is available at the end of each trading day.

Index Returns: Data Talks

S&P Indices Versus Active (SPIVA) conducts detailed research on the historic performance of thousands of actively managed funds. They then compare performance to the benchmark index. 

The results of their U.S. research are at the right. You can read SPIVA’s research reports on their Statistics & Reports Page for various countries.

U.S. Active vs. Passive Funds Graph

Here’s what SPIVA’s research finds:

  • 87.2% of all U.S. domestic funds underperformed the S&P Composite 1500 index over a 15-year period ended 30 June 2020
  • 84.5% of all U.S. funds underperformed the index over a 10-year period ended on 30 June 2020.
  • 97% of all funds in Canada underperformed the S&P/TSX Composite Index – Ouch!

We have two options. Either invest in the index or spend time trying to find the small number of actively managed funds that beat the market over the long-term net of fees.

Here is the kicker: Finding these funds is hard. A fund’s past performance is not a strong predictor of future performance. Many of the top performing 15 y ear funds fail to outperform in the future. 

You will see that a higher fraction of active funds beat the market in the short term. In fact, almost all active funds will have a year or two where they will beat the benchmark.

This is statistical noise, luck. The noise is damped out over time by something called regression to the mean.

Index Returns are Hard to Beat: The Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) tells us why the pros fail to beat the market in the long term. EMH states that all present info, and future earnings potential, and future risk are all priced into the market. If this is true, no one can beat the risk-adjusted returns of the general market.

Millions of people conducting analysis have bought or sold the stock based on available information to generate 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”. 

Put simply, it’s hard to outwit millions of people who are buying and selling stock as soon as new information arises.

EMH is not perfect. I think it misses important aspects of behavioral economics that lead to speculative bubbles and market failure at times. However, markets are efficient enough that it is nearly impossible to find misprices stocks. 

Index Funds Save Time

Your Time is Valuable

Your time is the only thing you can never get back! I don’t normally tell people what to do, but this case is different. You need to place value on your time. 

One of the best ways to spend money is to free up time.  Having control over your time is a core component of a wealthy life. It’s so important that I have an entire post dedicated to the topic.

Ask yourself, what is my time worth? You can then figure out how much you need to earn in excess of “the market” to account for the value of your time.

Stock Selection Efforts Drain Your Time

Building a portfolio of specific stocks is a ton of work. You need to learn how to read balance sheets and income statements. It is also important to understand industry trends and competition. 

Most importantly, you have to understand how the company makes money, and how it maintains competitive advantage.

That is a lot of work.

A pile of clocks

Dollar Cost Averaging With Index Funds

Dollar Cost Averaging (DCA) is a strategy where the same amount is invested at a pre-determined frequency. Common frequencies are: every paycheck, monthly, quarterly or annually.

I invest my savings every two months. I stick with this system regardless of what the market is doing.

Why does DCA work? You can’t time the market, nor can anyone else. The Efficient Market Hypothesis (EMH) and Random Walk Theory show that we cannot predict the market.

DCA prevents you from trying to time the market. It can even be automated through a brokerages for a completely hands-off approach. 

Even theories opposing EMH tell us that we cannot predict the market. For example, we can understand the characteristics of speculative bubbles to a degree, but we cannot predict when they will pop!

Invest as soon as money becomes available. You will naturally hit the highs and lows of the index, modulating volatility.

Most importantly DCA keeps our strong emotion-driven biases out of the picture. Systems protect ourselves from ourselves.

Management Expense Ratio (MER)

Index funds do not manage themselves. Both passive and active funds are owned by corporations and require fund management efforts.

Salaries, bonuses, infrastructure, and business overhead costs need to be paid by someone. These operating costs are covered by the Management Expense Ratio (MER). The MER is charged to people who put money in the fund.

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.

As already talked about lower resource requirements for passive index funds. The two factors that drive down index fund MERs are low management efforts and economies of scale.

Large funds are better able to leverage economies of scale because they have a larger pool of money for a fixed overhead cost. Index funds are normally larger than active funds.

Funds such as the Vanguard S&P500 ETF (VOO) are able to leverage huge scale to reduce fees. This specific fund has fees of 0.03% per year!

The MERs for passive funds typically range from 0.03% to 0.3% per year. You can find the MER on the fund’s website, and it should also be listed through your broker. Actively managed funds have fees that range between 1% to 2.5%.

MER Impact on Returns

MERs may seem insignificant, but they make a huge difference over the long-term. Two factors drive the impact of MERs: the fee directly paid and the forgone compound growth of paying those fees.

The second factor is the reason why fees have a bigger impact than we intuitively expect. Consider $10k invested for the first year in a fund with a 1% MER. You pay $100 in fees this year (1% of $10K). This is now $100 that will not undergo compound growth for the next 20 years!

How Fund Fees Impact Long Term Investment Returns

Diversity and Risk

Preservation of capital has been a principle of investing for over 4000 years, from Babylon. This means you don’t want to lose all your money. 

The purpose of most indices is to serve as a benchmark for the entire market. The entire market needs to decline for you to experience a loss of principal.

A few stocks that make up the index can tank, and they will be balanced out by hundreds of others that do well. For example, TSLA could go to zero tomorrow and the S&P 500 would lose around 1.7% all else held constant.

Further, entire economic sectors can do poorly, and they are balanced out by strong sectors.

The diversity of index funds reduces risk as much as possible for a given level of return. I understand if this is too abstract. To learn more, read Investment Risk and Risk Tolerance: An Introduction. 

No All Indices are Diverse

Beware, not all indices are diverse. Some represent specific sectors only.

For example, the NASDAQ is focused primarily on technology stocks, and the NASDAQ 100 index is even more focused on tech. The index is diverse within that sector by providing exposure to multiple companies. But its diversity ends there. 

Global Diversity

We can also diversify outside of the U.S and Canada into emerging and international markets. The globally diversified funds hold many other ETFs. 

VEQT is one example of an all-equity fund that holds over 12,000 global stocks.

Vanguard Total World Stock ETF (VT) is another.

Crashes and Equity Index Funds

Although index funds dampen the volatility of individual stocks, they can still be volatile crash. That’s why it’s important to have a long time horizon.

Recessions happen, bubbles happen and global uncertainty happens (COVID). Check out the history of the S&p500 and you will see some significant examples of market failure (1929, 2000, 2008, ect). 

I believe people should not invest in an equity index fund unless they are emotionally ready and willing to hold out a 50% crash.

It is extremely difficult to beat the risk-reward profile of most index funds!

Wrap Up

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 it’s nature, you will receive the market return, minus the tiny fees of the index ETF or index mutual fund. 

Not only will you save time, but you will beat the vast majority of professional stock pickers. I always smile when I write that. 

Furthermore, Index funds optimize long-term risk/reward trade off by eliminating the risk that you do not receive compensation for. 

I hope this provides you with a solid understanding of stock indexes, index funds, fund fees and diversification. 

I would rather spend my time working on this blog and progressing my career while I grow wealth slowly with index funds.

Jake out.