Investing Series: Investing in Index Funds

This is a part of the Investing Series.

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There are plenty of reasons to invest in index funds, and in generally, it’s suggested as a solid strategy for 90% of people, a sentiment that I agree with wholeheartedly.

This is why I’m going to start with index fund investing, which is what I’ve been doing for years, and what I’d recommend someone else to be doing with their money as well.

It is easy, it is passive and it doesn’t take a lot of time if you don’t have the inclination or interest to put towards it.

In the Investing Series, I’ll also go into other strategies and other questions that may have come up during my years of learning about my money, but this is the first thing I want everyone to learn about, and that is about index funds.

WHAT ARE INDEX FUNDS?

Index funds are a type of mutual fund.

Read: What is a mutual fund?

It’s a name given to mutual funds that basically track the stock market of a country.

Other mutual funds are called actively managed mutual funds, which are not “index mutual funds”, which are considered passive.

Actively managed funds means there’s a manager who is paid to take care of that fund and spend time reading, researching and finding stocks to pick for the best return, like this manager:

Manhattan Toy Whoozit

WHAT IS AN EXAMPLE OF AN INDEX FUND?

S&P 500 for instance was published in 1957, and is just a list of the top 500 U.S. companies.

As a result, it is considered a good representation of the U.S. stock market, and there are mutual funds built out there that mirror or track the S&P 500.

Other names an index mutual fund could be called by:

• Tracker fund
• Index-tracking fund
• Index Tracker
• Index fund

SO STANDARD AND POOR (S&P 500) IS NOT THE WHOLE STOCK EXCHANGE?

No, it isn’t.

It’s basically a listing of the top 500 common stock companies (hence S&P 500) that trade publicly on the U.S. stock exchange.

INDEX FUNDS ARE SIMPLE AND PASSIVE

You may be wondering: How hard can it be to track an index in a mutual fund that is basically already published for the world to see and use?

Not hard at all.

This not only saves you money because you won’t be paying for an actively-managed fund with an active fund manager, but they’re simple to understand and follow.

INDEX FUNDS DON’T NEED MUCH MAINTENANCE

Unlike stocks and keeping a stock portfolio, there really isn’t much to do except re-balance your portfolio 1-4 times a year.

Read: What does re-balancing your portfolio mean?

INDEX FUNDS ARE CHEAP

An actively managed mutual fund has higher Management Expense Ratios (MER), not to mention other hidden fees like buying and selling these funds (also called “no load fees”), and this is because you’re paying for someone to actively watch over the market, toss out stocks that are underperforming and pick up the winners.

The problem with all of this buying and selling is that it’s time-consuming for the fund manager, and they incur a lot of costs in doing so, which are all passed on to you — the unwitting investor.

Let’s take a look at TD Bank’s mutual funds (not their even cheaper TD E-Series) as an example:

The lowest funds in this list, are the ones that barely give you a return to justify that Management Expense Ratio (MER):

Just look at it — money market, bonds.. all of that is equivalent to “cash” to an investor’s eyes.

So if my “cash” is just sitting in the bank, barely making any money, why am I being gouged 0.16% to 0.77% for keeping my money in the bank each year?

I’d be better off putting it in a high-interest savings account. At least I’ll get the (possibly) higher 1.8% return on my money, AND not get charged a 0.16% – 0.77% fee per year.

Moving on!

The highest MERs are always the ones that are the riskiest like Emerging Markets or High-Growth markets like Asia or Brazil.

They charge almost 3% in MERs:

Now if we look at the difference between TD Mutual Funds and TD e-Series, the difference is sickening:

TD MUTUAL FUNDS — S&P 500 INDEX FUND

 

TD E-SERIES MUTUAL FUNDS — S&P 500 INDEX FUNDS IN CAD

 

The exact same fund but held in U.S. dollars, charges the same 0.35% MER, and the only one that charges more is the Currency-Neutral one:

 

So 0.54% versus 0.35% is a difference of 0.19%.

For currency-neutral, it is 0.89% to 0.51% or a difference of 0.38% (wow are they EVER gouging you!).

 

It may not seem like a lot of money to you right now (who cares about a percent of a percent!?), but if you start investing and building a larger and larger portfolio, it becomes a significant amount of money that you could keep in your pocket, simply because it’s e-Series and you have to learn how to click on a button to “exchange funds”.

Or learn how to buy them online (dead easy).

Want an even BETTER deal? Try Vanguard Canada.

 

I’m drooling over here.

The worst one is 0.49% and that’s for the super risky emerging market index, which as you might recall, TD Canada Trust doesn’t offer in their E-Series, and they were charging a 2.89% MER for it, or a difference of 2.4%!!!

THE ONLY ACTIVELY MANAGED FUND TO DO CONSISTENTLY BETTER THAN AN INDEX FUND COSTS $145,000 PER SHARE

I think the only famous and actively managed fund that has consistently returned more money than the average index fund, is Berkshire Hathaway led by this guy:

Warren Buffett, the Rainmaker

The problem is that Warren Buffett is ONE GUY out of millions who think they can do the same thing.

He has a memory for numbers that is a gift that ordinary people cannot replicate no matter how hard they try.

He is one in 6 billion, literally.

Now that we’ve established Buffett is a genius, do you know what Buffett says about the average investor?

“Warren Buffett said on Sunday most investors are better off putting their money in low-cost index funds”

(Source)

Hmm you don’t say.

WHY INVEST IN THE AVERAGE INDEX FUND VERSUS AN ACTIVELY MANAGED MUTUAL FUND?

If you invest in index funds, you’re investing in the average of the stock market.

Sounds boring right?

This is exactly the reason why a lot of people don’t invest in index funds.

SHEER FREAKIN’ BOREDOM.

You don’t have really do anything with an index fund strategy.

It is literally SET and GO. You just check on it once a year, if that.

It’s just so much sexier and enticing to read about an actively managed fund that returned 50% last year, and only had a MER of 2%.

So if you read that a passively managed index fund returned 10% last year in comparison, even though its MER was only 0.15%, you’d probably lose interest pretty quickly, even if it’s a steady, consistent return.

The one thing we miss out on, is that we should take a long-term look at the stock market in general, not a short-term look (1-year to 5-years is considered a short-term view).

If we look at an index fund representation of the stock market for the long-term of at least 25 years, it would look something like this:

S&P 500 Total Return (including dividends) since 1988 (25 years)

According to Standard & Poor’s, the dividends were responsible for 44% of the total return of the index over the past 80 years.

(I also recommend dividend investing for those of you who have mastered index fund investing, are bored with it, and are interested in learning something more time-consuming, but I will go into more detail later in this Investing Series about why it rocks.)

Even if you retired at the dips of the stock market in between 2000 and 2005, and 2005 to 2010, you’d still be ahead from when you started.

If you want play around with these numbers, check out Don’t Quit your Day Job’s S&P 500 Dividends Reinvested Price Calculator (With Inflation Adjustment) here.

Index investing is basically investing in the idea that the stock market over a long period of time will go up as an average, because as the world gets bigger, the economy will grow, and the stock market will go up.

REMEMBER TO LOOK AT AN INDEX OF A STOCK MARKET WITH DIVIDENDS REINVESTED

You have to remember to look at the TOTAL S&P 500 Return with dividends reinvested. They make up over 40% of the actual growth of an index (makes sense), and you’d be silly to just look at the S&P Index without taking into account the rest.

TD Mutual Funds E-Series do handle this:

The key words are: “Total Return”, here.

You can check out other indexes such as:

• Dow Jones Index (USA)
• Wilshire 5000 (USA)
• S&P/TSX Composite Index (USA and Canada)
• FTSE  100 (UK)
• FTSE All-Share (UK)

Keep in mind that indexes tied to a specific country will go up and down based on how well the country does.

INDEX FUNDS AREN’T SCHIZOPHRENIC

They have ONE investing style — the general, overall broad stock market.

There’s no jumping back and forth in strategies depending on whether the fund manager changes her mind, or whether they change out the fund manager for someone else.

One style. One idea. One path.

INDEX FUNDS VERSUS STOCKS

In regards to stocks, a lot of people will say that investing in index funds is silly and boring because you could earn so much more than the average on the stock market.

This is partly true because stocks that return more than the average stock market do exist, but the problem always comes in finding and choosing those winning stocks.

We simply don’t have enough money to invest in all the stocks that we want. Index mutual fund investing allows us to invest in hundreds of stocks (500, if you look at the S&P 500), without putting out a huge amount of cash.

It’s discouraging to add up the numbers and think: Wow, just ONE stock could cost me $600. I barely save that in 2 months!, and some people might give up at this point if that was what investing was all about.

Index fund investing is for the majority of folks (like me, when I started out) who have at least $25 a month to get started.

Look, if we all knew that Google or Apple was going to take off the way it did early on, and if we had plunked all of our money down on these two stocks, we’d be millionaires today.

Unfortunately, we don’t own crystal balls, and predicting the future of a stock (no matter how good it looks on paper), has 2 major flaws:

1. Human investors are irrational and we are prone to panic like wildebeests in a stampede
2. Even running all the numbers, doesn’t necessarily confirm whether it’s a good stock to buy or not

It’s still a bit of a guessing game with a lot more risk.

WHY I INVEST IN INDEX FUNDS

I currently have about 50% of my portfolio in index fund investing, this is for a few reasons:

1. I don’t like heart attacks and panic attacks on my money going up then down, then up…
2. I don’t want to spend my every waking minute checking the performance of stocks
3. I like that over time, index fund investing beats actively managed mutual funds
4. It’s low cost and I don’t like paying fees especially when I want moderate, stable returns
5. I also have a strategy for investing in stocks with dividends that make sense to me (more later)
6. I’m hedging my risk in a way, by investing in the overall stock market & also in specific stocks
7. I also have a third (mini) strategy for investing in stocks for capital gain (more on that later)

Basically, buying stocks and even researching dividend-paying stocks is time-consuming, you have to care about it, and do a lot of research.

It is basically sucking up at least 10 – 15 hours a week because I am in the midst of building a portfolio. If I buy a lot of companies, I have to spend the time to review each and every one.

Index funds? Kind of passive. Boring. Mundane.

It’s just as good as stuffing it into a savings account in my opinion, and a solid strategy for most investors who don’t want to bother with reading about financials on a stock, doing calculations, agonizing in their chair with a cup of tea of whether or not they should pull the trigger and buy the stock.

For playing with individual stocks for capital gain, I never play with more than what I can afford to lose, which is about 5% of my net worth.

I’m doing any kind of stock investing for fun, and I am not interested in losing the bulk of my wealth over night.

If you want MORE convincing from far smarter people than I, you should read this book I was given when I first started my career and then started investing: Index Funds: The 12-Step Recovery Program for Active Investors

It is as funny as the title 😉

Or at least, as funny as you can make index fund investing seem.