Index Funds?? What are they

Index funds provide a convenient way to invest in a diverse range of companies all at once. One prominent example is the S&P 500, which tracks the performance of the 500 largest publicly traded companies in the United States.

Since its establishment in 1957, the S&P 500 has consistently delivered an impressive average annual return of 10.31%. This means that, on average, investors have seen their investments grow significantly over time, reflecting the overall growth of the U.S. economy and providing a relatively stable option for long-term investment.

By choosing index funds, investors can benefit from this broad market exposure without the need to select individual stocks.

Simply an ‘index’ is a list.

In the world of index funds, an index is simply a list of businesses or other investments. For example, the S&P 500 is a list of the 500 biggest businesses in the US.

A ‘fund’ is a pot of money collected from different investors, used for a specific purpose.

An ‘index fund’ is therefore a pot of money that invests in a specific list of businesses.

Think of index funds as an all-you-can-eat stock market restaurant, where you can sample a diverse array of investment options instead of having to commit to just two or three. This analogy highlights the appeal of index funds: they allow you to gain exposure to a broad range of companies and sectors without the high stakes of selecting individual stocks.

If you have any form of a pension plan, there’s a good chance you already have some exposure to index funds. Pension providers typically use these funds as part of their investment strategies, investing on your behalf. However, it’s important to be aware that they may charge additional fees for managing your investments, which can affect your overall returns.

Index funds are available that specifically track and invest in the companies listed in the S&P 500. This index represents 500 of the largest publicly traded companies in the U.S. While the S&P 500 is a popular choice, it is just one of countless indices that exist. In fact, there are thousands of different index funds, each focusing on diverse investment areas and strategies.

To simplify things, you can categorize index funds based on factors such as the size of the companies they invest in or their geographic location. For instance, some funds concentrate on large-cap companies in developed markets, while others may focus on smaller companies or emerging markets. Additionally, you'll find funds that target specific countries or regions, as well as those that are globally diversified, covering businesses from all around the world.

The variety among index funds is vast, with differences that can range from subtle variations—like the type of index they track—to more pronounced distinctions, such as the sectors they focus on or their investment strategies. We will delve into these variations in more advanced lessons to give you a comprehensive understanding of your options.

As an investor, your primary responsibility is to decide which index or indices you wish to track. This decision will significantly impact your investment strategy and long-term financial goals.

Here are three examples of index funds to illustrate the diversity among these investment vehicles:

1.Fidelity Index World Fund P – This fund aims to provide investment exposure to global developed markets, encompassing a wide range of industries and sectors.

2. iShares S&P 500 Index Fund – Managed by BlackRock, this fund focuses on the largest companies in the U.S., allowing investors to capitalize on the performance of well-established businesses.

3. Vanguard FTSE Global All Cap – This fund takes a more expansive approach by investing in companies around the globe, covering various geographical regions and market capitalizations.

The names of these funds can sometimes be confusing or overwhelming for new investors. However, it’s essential to understand that you can easily research what each fund invests in with a quick online search of its name.

The three funds mentioned above are managed by reputable financial institutions: Fidelity, BlackRock (for iShares), and Vanguard. Each fund has a distinct investment focus; for example, the Fidelity fund targets global developed markets, the iShares fund concentrates on the largest U.S. companies, and the Vanguard fund invests broadly across the entire world. Understanding these differences can help you make more informed investment decisions tailored to your financial objectives.

Why would you use an index fund?

Before we delve into the risks associated with investing, it’s important to highlight three fundamental reasons why index funds merit serious consideration:

1. Underperformance of Beginner Investors: A staggering statistic reveals that over 90% of novice investors who attempt to pick individual stocks end up underperforming the overall market in the long run. This underscores the challenges and complexities of stock selection.

2. Strong Historical Performance: Since its founding in the 1950s, the S&P 500 index has produced an impressive average annual return of 10.31% before factoring in inflation. This long-term performance illustrates the potential benefits of a buy-and-hold strategy with diversified investments.

3. Comparative Outperformance: Research consistently shows that index funds often outperform actively managed funds over extended time periods. Actively managed funds require managers to actively trade stocks in an attempt to identify undervalued opportunities. However, this approach does not guarantee superior returns and can sometimes lead to higher costs for investors.

To illustrate the compelling nature of index fund investing, consider this scenario: If you consistently invested £200 each month from your 18th birthday until you turned 50, reinvesting any dividends received, and achieved the historical average annual return of 10.31%, your total investment of £76,800 would grow to an astonishing £603,672.69. 

This example highlights the power of compound interest and long-term investment strategies.

Despite many investors believing they possess the skills to outperform the market,  evidence indicates that index funds generally yield better results than professionally managed funds. A report by The New York Times found that none of the 2,132 actively managed funds analysed managed to beat the market over a relatively brief time frame of five years. This short analysis reinforces the idea that even well-paid professionals struggle to consistently outperform a simple indexing strategy.

Further research that spanned a much longer period of 23 years discovered that global index funds exceeded the performance of actively managed funds by an average of 1% per year. Such findings imply that a straightforward strategy of buying and holding all the companies within an index has the potential to outperform even the highest-profile finance experts, who devote their careers to market analysis.

Notably, esteemed investor Warren Buffett has publicly advocated for investing in low-cost S&P 500 index funds. In his view,

 “The ‘know-nothing’ investor who diversifies and keeps costs minimal is virtually certain to achieve satisfactory results. Indeed, the unsophisticated investor who is realistic about their own limitations is likely to achieve better long-term results than a knowledgeable professional who might overlook a single weakness in their strategy.”

While it is essential to acknowledge that no investment comes without risks, index funds have historically proven to be among the safest and most effective long-term investment options available.

The inception of the first global index fund occurred in 1976. Historical data indicates that if you had invested on any given day from the fund's creation until today, you would have a remarkable 94% chance of realising a profit if you maintained your investment for 10 years or more. This probability increases with longer investment horizons while decreasing for shorter periods (73% for one year, 66% for three months, and 52% for just one day). This data emphasises the importance of patience and a long-term perspective in achieving investment success.

What are the risks?

Investing in index funds carries a fundamental risk: you can lose money. All investments have inherent risks, and their values can fluctuate. Despite past successes, there’s no guarantee that index funds will continue to perform well in the future. Remember, past performance is not an indicator of future results

While the global market has generally trended upward over the long term, there will inevitably be years of economic instability and market volatility. This means that losses are not only possible but likely if you look at shorter time frames.

Here are some specific risks associated with index funds that relate to potential losses, either directly (through a loss in value) or relatively (when compared to other investments):

- Tracking Error: Your fund may not perfectly track the index. Although the goal is to follow the index closely, it will never achieve perfect alignment.

- Lack of Flexibility: If the market experiences a crash, you won't have the flexibility to move into alternative assets.

- No Automatic Stop-Loss: There is no mechanism to automatically cash you out during a sudden drop or crash in price.

If you choose not to invest in a global fund or an S&P 500 fund, you are making specific bets on other market conditions.

For instance:

- FTSE 100 Fund: Investing in this fund means you are betting on the UK economy, as it tracks the 100 largest companies in the UK

- Emerging Markets Fund: This fund covers a range of emerging economies, including Argentina, Hungary, and the Philippines, as well as larger economies like China and India—both of which are wealthier than the UK

The specific risks when selecting individual funds include:

- Your investments might decrease in value.

- Your investments could underperform compared to funds in other sectors.

- The more specialized your investments, the greater the risk and variance in your profits and losses.

As previously noted regarding index funds, the typical strategy is to avoid being too specific. If broad market investments can be profitable, why attempt to outperform the market in a way that even the most astute financial experts find difficult? Many would argue that trying to do so resembles speculation or gambling rather than true investing.

Short-term fluctuations are to be expected, and ‘short-term’ in the context of index funds typically refers to any period under ten years. A chart from MacroTrends illustrates how the S&P 500 experiences significant ups and downs each year, despite an average long-term return of around 10% per year.

If you started investing in S&P’s index in 1928, 4 of the first 5 years would have produced losses!

Most people who invest in index funds typically plan to do so for at least 10 years, often for as long as 30 or 40 years. Compounding is incredibly powerful, as demonstrated in a previous example, but it usually takes over 20 years to truly start making a significant impact.

 For instance, if you invest £200 every month for 35 years with an average annual return of 10%, by year 35, you would earn £72,468—more than the total of £66,540 you would earn in the first 17 years combined.