Why Index Funds are Good
An index fund, sometimes called a ‘passively managed fund’, is another type of mutual fund like an actively managed fund except that instead of a hopefully clever human, an algorithm does the investing for you. It blindly invests in the whole market, attempting to track a stock market index . . .
Let’s say a hypothetical index fund is designed to track the S&P 500. Some do. If Apple Inc. is 2% of that market, the index fund robot will invest 2% in that company. If Apple’s share of the market rises to 3%, the algorithm will raise its investment to 3%. And so on. Or at least, it approximately does this, and it repeats the process for enough other stocks so that the performance of the index fund will end up being almost exactly the same as that of the index it is tracking. Different index funds track different stock market indexes or combinations of indexes.
This is important to note: an index fund attempts to match, rather than beat, the market. If the average return of the market one year is 11.9%, a good index fund ought to make 11.9%, too. If the market falls 3.8% over the year, your index fund should also fall by 3.8%. The idea is that the average return, over the long run, is pretty good (maybe 8% or so), and that achieving more than that is impossible for most of us anyway.
Check the fine print to see exactly which index, or group of indexes, a fund is tracking. There ought to be some data provided so that you can confirm how closely it is tracking for yourself. If the actual performance is too far off the ‘benchmark’ (the index that it is supposed to be tracking), there must be something wrong.
The one big, big advantage of index funds is that they offer low fees. Seriously low. They vary, but some offer rates of 0.35% for amounts over $100,000 [Edit: this figure comes from funds offered in Australia but fees have recently been cut to around 0.18% for some funds, regardless of investment amount]. In the US, Vanguard’s fees can be less than even that. Index funds are by far the cheapest and easiest way to invest in shares.
There are various index funds around, and there are more options in some countries than in others. Personally I like the flexibility of Vanguard’s selection and the prices are very competitive. Go to www.vanguard.com and you’ll be redirected to their main page. If you are American, this is your website. If you are not, scroll down to the bottom and click on the ‘Non-US Investors’ option to find the Vanguard site for your country. Hopefully there is one. If not, you might need an advisor to help you find something suitable (see Step 9).
Check what products they have available in your country and compare with other index funds. You might find another that suits you better or offers lower fees. However, Vanguard was the best I could find in Australia. I get no kickback from those guys. If anyone from Vanguard is reading, please contact me if you’d like to give me one.
Does something ring a bell? It ought to. Back when we were talking about diversifying bonds, I showed you that the easiest way to do this was to buy an index fund of many bonds from a provider like Vanguard or BlackRock. And now, to diversify your shareholdings, you can basically do the same thing: pick out a suitable index fund of shares from the same provider.
[Edit: these days there are many specialized index funds/ETF that track specific sectors or types of shares. You don’t want these; you want a fund that invests in everything. Also, international diversification is discussed elsewhere in the book.]
Recap of Stock Diversification
Picking your own stocks is time consuming and very few do well out of it. Actively managed funds have high fees. Index funds, also called passively managed funds, are cheap and easy to use. They are by far the best option for most investors. ETFs are the same thing but can be easily traded online.
After that lengthy discussion about diversification, it turns out that all you need to do is go to a website, pick out suitable share and bond index funds, and put your money into them according to the risk profile that you figured out earlier. There’s a little more to know, but you’ve already got the basics at this point.
I told you it would be easy.
Vanguard Index Funds Available (Retail)
Australia: [Edit: they’ve just been greatly expanded. There are now heaps but still not as many as in the US or UK.][i]
Canada: Thirty domestic and international stock funds, five diversified funds, plus some actively managed funds.[ii]
New Zealand: NA. Follow the link at the endnote for alternative ways to invest in Vanguard.[iii]
United Kingdom: Six UK bond funds, four European bond funds, seven international bond funds, five UK stock funds, six European stock funds, 23 international stock funds, and sixteen diversified funds (including ‘targeted retirement’). There are also some active funds.[iv]
United States: Eight money-market funds, 36 US bond funds, four international bond funds, 35 US stock funds, 20 international stock funds, 24 balanced (diversified) funds and eighteen alternative/specialty funds.[v] Some of these may be actively managed; I did not have time to investigate them all.
Vanguard funds are also available in various other places.[vi]
Check out the main page of the biggest competitor via the endnote: BlackRock.[vii]
Also available on many other platforms.