Good morning RIPvestors,
welcome to another post in the investing series, where I gradually introduce you to the world of investments and go deep on topics I have some experience with, mainly related to investments in Switzerland.
Other posts in the Investing series:
- Investing basics
- Financial Investing
- Funds Investing
- Fees & Taxes
- Stock Price and Market Model
- Investor Profile and Lifelong Investing Strategy
- ETF 101
- Stick with it
- My take on Cryptocurrencies – Part 1: The Ugly
- Interactive Brokers 101
In this post I’m going to dig into investment funds, market index and index funds. This is still a basic post: if you’re an experienced investor you can skip it. If you’re are new to stocks and funds I hope you get some value from it.
In the previous post I introduced you to the world of banks, saving accounts, bonds and stocks.
I left you with a nice investing strategy: “Probably the simplest and best alternative for an average investor is to buy stocks of a lot of companies, ideally stocks of every company on every market”
How to do that? Not alone, obviously. You need to join a fund.
An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group.
Cool. Instead of doing it alone, you join a group with your capital and together you’ve more purchase power than individuals. Someone, externally hired, can manage the fund and costs may be lower than acting as individual. Super!
How does a fund work? Well, there are tons of fund types. Let’s keep it simple here. Essentially you put money into the fund and you get a share of the fund. The fund invests your money on different assets, according with the fund investment policy, and you get a share of the overall return of all assets, minus fund’s managements costs. The return you have is in form of both dividends and fund’s shares appreciation.
Funds don’t have to be stocks based. There are funds that invest in bonds, real estates, currencies, precious metals, whatever else or a mix of all of these. There are pension funds, like UBS Pillar 3 Vitainvest funds (I’m not advertising them, that’s just the subject of one of the latest spammy mails on my inbox) that implements assets category diversification: bonds, stocks, real estates. In theory, one can just buy shares of a fund and implement enough diversification.
“Awesome RIP, thanks again! Let’s put all my money in a fund! Where do I find them? Tell me more 🙂”
Funds are managed by financial institutions. They’re getting very popular and today almost everyone owns shares of at least a fund (do you have a pension fund?). Funds may be actively or passively managed and this is one of the key characteristics you want to care about.
Actively managed funds are funds that have a battery of experts that study the market and try to perform better than the average. As you can imagine, they come with a cost. Having someone (many) manage your wealth is expensive, since they have to be paid. This translates in high yearly fees, in the order of few percent points (1-3%) of the total fund’s capital. It is 1-3% of your investments, every year, that disappears. If your fund is not performing 1-3% better than your “random stocks” strategy then you’re losing money. What’s the point?
Sure, they have better tools than the financial adviser we pretended to hire in the previous article of the series: your battery of experts have a company behind, better computers, better algorithms,… still they’re not so consistently good at this task.
And please, don’t underestimate the influence of the management costs over the long term.
“Well, RIP, funds are cool. They let you diversify enough since you don’t have to buy yourself. But apparently they cost a lot. We’re back at the starting point. I’m better off buying random stocks. It’s getting depressed. Should I hire a monkey that buys my random stocks?? Wait… You introduced the passively managed funds. What are they?”
You’re right. Probably you’re better off with either the “become and expert” or the “random stocks strategy” than trusting an actively managed fund. Is that all? Are there any other alternatives?
Maybe worth mentioning that funds are not just for stocks. For every liquid or illiquid investment sector you can find a fund investing on it. You want to invest in real estates but don’t want to go shopping for houses? Buy a share of a fund that invests in real estates! You’re trading your mental energies for costs billed to you by the fund manager. Their costs may be way smaller than yours since they work with higher volume.
Anyway, if we want to restrict our analysis to the stock market, you may have noticed I mentioned passively managed funds.
A passively managed fund is a fund that doesn’t require much human effort to be managed. And no, they’re not exploiting underpaid monkeys to do the job 🙂
How do they work? Before jumping right to the solution, let me introduce the concept of indexes.
Stock Market Indexes
According to Wikipedia:
A stock market index is a measurement of the value of a section of the stock market. It is computed from the prices of selected stocks (typically a weighted average)
Have you ever heard about Dow Jones? Or Nasdaq? Or S&P500? Or (italian) Mibtel / Mib30? Or (European) Stoxx600? Those indexes provide an aggregate measure of a market performance. It’s like an inflation/CPI index where products are considered in weighted amounts to represent their volumes in the consumers consumption.
An index is composed by several shares per company to represent their volumes in the market the index is tracking. For example, the S&P500 tracks the 500 largest american companies by capitalization. It is defined by N1 stocks of company 1, N2 stocks of company 2, … N500 stocks of company 500, where N1,N2,…N500 values are there to make (Nx * Sx) / Cx constant for x in [1,500]. Sx is Stock price of company x, while Cx is its capitalization. Nx changes over time according with market changes: stock values change, companies capitalization change and even the company list changes. Companies come in and out of the top 500 every day.
How awesome would be to invest in a portfolio that behave like the S&P500 index?
What? You asking why?? Did I mention you may want to diversify your investments? The more you diversify the less you risk your principal (the invested capital). At the same time, the less you diversify the more you may potentially earn, at the cost of greater risks. It’s up to you. If you’re young and you have decades of working years ahead of you, you may handle extra risks. If you’re like me and you care mainly of not losing your principal… well, matching an index is enough of a return!
Ok, cool. So now the problem I guess is “why the S&P500?“. I don’t want to advertise the S&P500 index or any index in particular, even though the S&P500 is a very good index to track, since it has guaranteed more than 10% return per year over any 25 years period of time so far. You don’t trust it? Well, you’re right. Past performances are not a guarantee for future returns. But still, that’s how the economy worked in last 250 years so it’s likely to keep up with the pattern. Take a look at another index for which we have slightly more data (i.e. since 1789): the Dow Jones. Here’s a chart:
But ok, let’s not be biased towards US markets: there are indexes that track everything. Large companies, tech companies, american companies, small companies, asian companies, travel companies, real estates companies, financial institutions, consumer staples, African companies, European companies… there are indexes for everything!
You track an index, you diversify. You split your investments and track more indexes, you diversify even more. Isn’t it cool? Did I convince you?
Now, how to implement this? Funds, funds everywhere, funds again!
Index Funds are investment funds that do their best to match an index in their portfolio. The actual definition is more complex and I send you to wikipedia for that.
Essentially: you, as a small investor, can’t (or don’t want to) reproduce an index in your portfolio due to your limited capital and the amount of time it requires to follow the market evolution and buy/sell stocks according to it (it’s called rebalancing, we’ll face this problem later anyway). So instead of diversifying manually, you just buy a portion of a fund that implements the diversification.
Matching an index can be done programmatically, so no need to hire experts. Index funds are passively managed funds. Yes, we’re connecting the dots!
What are the advantages of investing in an index fund?
First, funds fees can be very low since not that much of human supervision is required. Yearly fees are in the range of 0.07 – 0.3 % of the funds value. It’s less than 10% of actively managed funds fees.
Second, you’re essentially matching the index your fund tracks. No surprises but market related ones.
Third, you implement diversification with less effort.
“RIP, you convinced me! I’m going to invest all my money into an index fund that tracks the S&P500 index 🙂”
Good! Well, not exactly. Let’s design your strategy together.
- You want to have an emergency fund, so keep some money on a checking/saving account. Better to have a fixed amount, not a percentage of your NW.
- Differentiate in asset types. You probably don’t want to invest 100% of the not-cash in stocks. Invest a portion in bonds for example. Take a look at some reference portfolios. Define your strategy. Some suggest to invest in stocks no more than “100 – your age” percent, to gradually move away from risks as you get older. Writing an IPS helps.
- Once you figured out which percentage of you capital you want to invest in stocks, define in which markets you want to invest. You have this written in your IPS haven’t you? Find indexes that tracks your markets, find funds that track your desired indexes, detect which one is better from a performances/costs/taxes point of view (you may actually differentiate within the same index, buying shares of more funds), invest in each of them your planned fraction of your NW.
Ok, cool, we have a strategy to get you started! Now let’s see which questions we have left to answer:
- How to chose indexes I want to track?
- How to chose an optimal allocation?
- How to invest over time? What to do with my future savings?
- How to chose a particular fund given an index I want to track?
- how do I physically buy a share of a fund?
- Do I need a broker account or is it enough to go to my bank?
- How to choose a broker?
- when should I buy?
- when should I sell?
- What to do when the market crashes?
Welcome to the financial world! We’ll face these questions later in this series.