Index Investing: The Best Choice For Passive Investors

Index investing




Index investing is a way of gaining exposure to an investment market. It requires less research because it is an investment in all of the securities in an index. Even for those with little investment experience; index investing is easy to understand. It doesn’t require insider knowledge, or a degree in finance, or anything other than a few minutes of time.

This blog post is sixth in a series of posts called – “All You Need To Know About Different Investing Strategies“.

Index investing

The basic principle is that by buying a product that tracks particular index – either via an index tracker fund or an Exchange Traded Fund (ETF) – investors automatically create a portfolio of investments that are as diverse as the companies that make up the index.

Once they select the indices they wish to track, it is usually simple to set up regular contributions via their stockbroker and because the constituents of the index change over time there should be little need to rebalance their portfolio as it is effectively done for them. Then, they can sit back and relax –but they’re in for the long haul and their aim is to match as closely as possible to the market (index) return while minimizing transaction costs incurred.

"Don't look for the needle in the haystack. Just buy the haystack!"
Jack Bogle
"Trade Gyani"

Should You Invest in Index Funds?

Index Investing

The popularity of index funds has exploded over the past 20 years, creating a rich subject for scholars and commentators. They are considered passive because try to match a predetermined set of stocks rather than beat the market. 

Risk-averse investors should lean toward index funds. In fact, a randomly chosen index fund performs better than a randomly chosen active fund after accounting for risk. It’s easy to assume that investing, like cooking, requires skill to get the right mix of ingredients. But that’s not the case with index funds. 

Effort goes into building them, but these ready-made investments need minimal intervention. Yet the outcomes are appetizing indeed.

Once they select the indices they wish to track, it is usually simple to set up regular contributions via their stockbroker and because the constituents of the index change over time there should be little need to rebalance their portfolio as it is effectively done for them. Then, they can sit back and relax –but they’re in for the long haul and their aim is to match as closely as possible to the market (index) return while minimizing transaction costs incurred.

Means of Indexing Insvetments

Indexing being passive in nature, there are only two options via which you can invest.

Exchange Traded Funds

Exchange Traded Funds, or ETFs, are essentially Index Funds that are listed and traded on exchanges like stocks. Exchange Traded Funds (ETFs) are one of the fastest growing investment products in the world. ETFs are bought and sold on stock exchanges like regular shares. By investing in ETFs can include stocks, bonds and cash.

Enhanced Index Funds

Enhanced index funds combine the best of both passive and actively managed funds. They offer low operating costs, low turnover, and diversification. Moreover, they implement a variety of enhancement strategies to try and beat the return of the tracking index. Enhanced index funds can be more profitable than regular index funds.

How to select an Index Fund?

Index funds can be very beneficial, especially for those investors, who do not have much knowledge about investing in stocks nor have the time to research and find good, actively managed funds. Before investments, investors are first going to need a brokerage account. If they already have one, feel free to jump to the next step!

Indexing being passive in nature, doesn't require much effort. However keeping below in mind helps increase the returns further.

  • Keep in mind that index funds don’t really vary from firm to firm. So look for a provider with a good reputation for offering low-cost, no-load funds (that doesn’t charge commission for each sale). It’s because index funds may lose higher value during a market downturn. It’s always advisable to have a mix of actively-managed funds and index funds in their portfolio.
  • Before investing in an index fund, they need to shortlist a fund which has the minimum tracking error. The lower the number of errors, the better is going to be performance of the fund.
  • The real differentiating factor between two index funds will be their expense ratio. The fund having a lower expense ratio will give marginally higher returns.
  • Those who choose index funds must be patient enough to stick around for at least that long. Then only, as an investor can realize the fund’s full potential.
  • When they redeem units of index funds, they earn capital gains. These capital gains are taxable in their hands. The rate of taxation depends on how long they stayed invested in index funds i.e. the holding period.

Calculating the return of Index Funds

To calculate the returns follow these steps:

  • Find the price level of the chosen index on the first and last trading days of the period investor are evaluating. Be sure to use the opening price on the first day and the closing price on the last in order to make sure their calculation is as accurate as possible.
  • Next, subtract the starting price from the ending price to determine the index’s change during the time period.
  • Finally, divide the index’s change by the starting price, and multiply by 100 to express the index’s return as a percentage.

Famous Investors Associated with Growth Investing

(May 8, 1929 – January 16, 2019) He was an American investor, business magnate, and philanthropist. He was the founder and chief executive of The Vanguard Group, and is credited with creating the first index fund.

He is an American investment consultant. In 1972, Ellis founded Greenwich Associates, an international strategy consulting firm focused on financial institutions. Ellis is known for his philosophy of passive investing through index funds, as detailed in his book “Winning the Loser’s Game”.

He has been an industry leader in index investments for more than 25 years. Charles R. Schwab launched the Schwab 1000 Index in 1991. His goal was to give investors a simple, low-cost way to participate in the growth of the country’s largest companies. 

In any investing strategy, its difficult to leave Mr. Buffet out. He is like Sachin Tendulkar, if there is a worthwhile stat, he will feature. This however is an exception, he didn’t invest in an index fund, rather bet on one. Read further and you will start appreciating the power of Indexing.

In 2007, legendary investor Warren Buffett made a $1 million bet against Protégé Partners those hedge funds wouldn’t outperform an S&P index fund, and he won. “The trick is not to pick the right company,” Buffett says. “The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently.”

Final Thoughts

Some people make investing their hobby, and derive serious enjoyment from researching and trading stocks. But that’s not for everyone. Others are happy to pay financial advisors for the convenience of not having to think about their investing. And if they can afford it, more power to them. But if anyone who wants a low-maintenance, low-cost way to invest his money, for retirement, for a home purchase or for any other financial goal, it can be a good idea to look into index funds. He’ll have the satisfaction of knowing that more of his money is growing and less is going to pay fees. 

Write a comment