diversified portfolio is like splitting your investments among these jars

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You’ve probably heard of index investing. In fact, if you’ve heard of Jack Bogle and Vanguard, you’ve almost certainly heard of index investing. Jack Bogle was the founder of the Vanguard Group, which created the first index mutual fund.

Why does this matter?

Index investing allows investors, including individual investors, to get broad market exposure at a relatively low cost. With index investing, a fund holds the components of a predefined investment index.

The manager of the fund is responsible for ensuring that appropriate amounts of the index components are held in the fund rather than being responsible for choosing what securities to hold. An investor then buys into the fund. This allows investors to have exposure to each of the components of the index without having to actually purchase and hold shares in each of the companies that make up the index. As an investor, you could choose to invest $10,000 into an index fund even if purchasing single shares of every company in the index might require a $20,000 investment.


What Exactly is an Index?

An index is a collection of investments that have some factor in common distilled down to a number that represents the aggregate performance of the component pieces. Examples of indexes are the Dow Jones Industrial Average (DJIA), the S&P 500, and the Nasdaq 100 index, which are broad-based indexes often used to gauge the performance of a broad market. Then there are indexes intended to provide information on the performance of certain segments of the market, such as the Russell 2000 Index, which includes small-cap stocks, or the PHLX Semiconductor Index (SOX), which tracks the performance of companies that produce semiconductors. 

The calculation of the value of the index varies from index to index. For instance, the DJIA is a price-weighted index meaning that the value is computed based on the price per share of each of the components. On the other hand, the S&P 500 index is calculated based on the market capitalization, the total number of shares outstanding multiplied by the price of the shares of each of the components. Some indexes use a combination of price, market capitalization, the aggregate market capitalization of all securities in the index, and other factors. Since the calculation of these indexes varies widely, it often makes more sense to pay attention to the change and direction of change of an index rather than the index value itself.

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Who Creates an Index?

Indices can be created by anyone. However, the most well-known and followed indexes are often created by fund managers, investment banks, or brokerages. See our recent post about the history of the Dow Jones Industrial Average. The creator of the index defines the concept behind an index and the rules that will apply to the index, including how component securities will be chosen and the calculation of the index value. Then, the index provider will start calculating and communicating the index according to the method and rules they have established.

Periodically, the index may need to be rebalanced to bring it back in line with the established methodology due to events like mergers, spin-offs, stock splits, etc. Ultimately, the index provider makes money on their index by licensing their indices to portfolio managers who may build products like ETFs and mutual funds from the index. In addition, the index providers can license the index to media that report the value of the index in real time.


What’s the Benefit of Index Investing?

One of the benefits of index investing is that it removes stock-picking and market timing from the picture. If you buy into an index fund, you will be gaining exposure to the components of that index based on the weightings established by the index at the current price. There is no waiting for the price of a particular company’s stock to reach a certain level, and there’s no guessing when to sell a particular stock because it might be at its high. All of the buying and selling of individual securities occurs based on the rules of the index.

It provides broad exposure to a segment of the market at a relatively low cost. To buy just one share of the 10 largest companies in the S&P 500 index would cost you at least$8000. Or, you could get exposure to 500 companies with just a small investment by purchasing shares in an S&P 500 ETF or mutual fund.

And the index acts as a benchmark. You would think that all funds based on the S&P 500 would have the same performance, but you’ll find that isn’t necessarily true. One reason may be due to the difference in expense ratios charged by different funds. Another reason may be due to the timing of trades when the fund ensures alignment with the index. And there may even be a difference depending on the pricing that a large broker-dealer who provides a fund can get versus a smaller fund provider.

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Are There Drawbacks?

There’s always a balancing act when deciding to let someone else choose your investments. Both ETFs and mutual funds have fees associated with them. Part of those fees go towards marketing those funds and paying for the folks who keep the funds compliant with regulations and reporting requirements, as well as the actual traders. But another part of those fees pays for the licensing of the index being used by the fund.

In some cases, the portfolio manager itself is providing the index and managing the fund. This can work out in their favor or the investor’s favor depending on the licensing fee being paid for the use of the index. With a widely-used index, there are many licensees paying the fee for the license, and therefore, it is likely a lower fee. With indices without a broad-based following, you may see the portion of the fee going to the licensing company is rather large.

Another potential drawback is that indices generally have rules regarding the timing of additions and deletions from the index and when the index is reconstituted. This could mean that a company that you feel is a poor investment is still in the index when you might have sold that stock if you managed the funds yourself. This is part of the price you pay for broad exposure for a relatively low cost.


Is Index Investing the Answer?

As usual, the answer is “It depends.” It depends on the question you’re asking, and it depends on your goals and available resources.

Index investing does take the emotion out of investing, for the most part. You may still try to time the market when buying into a particular sector, but you won’t be trying to time the market regarding a particular company. Index investing does allow investors to gain exposure to a large number of companies without needing the capital to buy actual shares in each individual company. But, you do give up a degree of control in exchange for using the funds that depend on predefined indices.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

 

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