Investing for Beginners: What are index funds?

It is very common for people, especially those with little experience in the financial market, to be interested in investment models that convey comfort and security in their applications and don’t require a deep and dynamic knowledge of all variables of the financial market.

For these investors, index funds are a good alternative. However, even though this is an investment modality that doesn’t require the total dedication of its users, basic knowledge is necessary to maximize long term returns. It also enables greater comfort to the investor, ready to learn about it?

Index funds

As the name implies, these are investments that match or track a certain market index, such as the Nasdaq Composite or S&P 500. Although conservative, they tend to have more advantages. Several studies show that passive index funds have beaten the profitability of most diversified equity funds on the market.

Since this fund’s job is primarily to track indexes, management fees are typically less than 0.5% per year.

Understanding the concept of passive investing

Passive investing is about achieving the returns you need in the market by using low-cost index funds and exchange-traded funds. The passive investor seeks to equate their profit margin to market results. Managing the expected return, defining an asset allocation and maintaining this composition over time. Therefore, passive investments are ideal for those who don’t have the chance to monitor the financial market.

In recent years, investments in passive funds have gained ground in portfolios around the world. In contrast to active funds, passive funds gained support due to its low costs.

Active investing

Active investing is the kind of investment that tries to beat the market by using an infinite number of high-cost strategies.

To build a stock portfolio, for example, you need to analyze several companies and choose at least 10 to 15, to diversify risks and track those stocks. The investor pays for this work through the management fee and often also the performance fee.

As a result, part of the return on the investment is given to the fund for the management of this portfolio, resulting in a lower final return. Furthermore, this final return is equal or even lower than expected.

When investing in a fund that follows a certain index, the investor will have that index profitability. They'll also pay only a very low management fee. Thus, they’ll have a diversified portfolio with all the shares that make up the fund, paying very little for it.

Is it possible to beat the market?

This is the fundamental question that needs to be answered before making a decision.

Passive investment is supported by those who believe that, in the long run, it’s not possible to have higher returns than investment ratios. This thinking is based on the theory of an efficient market created in the 1960’s by the economist Eugene Fama.

According to this theory, market prices already fully reflect all information and expectations. In other words, there are no assets in the market that are cheap or expensive. All are already properly priced. A change in pricing only happens with random and unpredictable events.

Therefore, no differentiated analysis can consistently achieve above-market returns. A return above the market average, known as benchmark indices, is just a matter of luck. Also, the return that the manager could achieve above the market could be lost on the fund costs necessary for its operation.

In recent years, the U.S. hedge fund industry has been heavily charged for failing to achieve above-market returns. This strengthened the passive fund’s thesis.

In short, passive investment supporters believe that there are only a few exceptions to the rule that index funds are the most effective in the long run.

Dow Jones Industrial Average and S&P’s 500

The most famous index of all time, the Dow Jones Industrial Average, is a list of thirty blue-chip stocks. The list is a representative collection of stocks from companies that are important to the U.S. economy.

Over long periods of time, the DJIA has beaten many other indices, including the famous Standard & Poor’s 500.

S&P’s 500 started in 1923 and since 1957 has sustained its current count of 500 stocks. It is the most widely discussed index in the world and has a more complex methodology than the DJIA.

In both cases, you still own a portfolio of individual stocks held in a pooled structure with a portfolio manager. The portfolio manager is responsible for getting results as close as the index as possible.

Types of index funds

Although DJIA and S&P 500 are the most popular ones, there are several others to the point that you can find an index fund to every financial market in the world. 

For example, the MSCI USA Enhance Value searches for medium and high capitalization stocks with the most attractive valuation.

Another way to select companies is by industry so that you can have access to all sectors that exist. For example, Power Shares QQQ, managed by Invesco Power shares are traded on the Nasdaq and follows the Nasdaq-100 index of technology companies.

Vanguard FTSE Emerging Markets (VMO) is managed by Vanguard and traded on NYSE-Arca and is composed by 1,000 shares from companies from emerging countries like China, Taiwan, India, Brazil, South Africa, Mexico, Malaysia, Russia and others.

Others select stocks within continents and can be North America, Europe, Asia, Oceania, Africa and so on. One example is the SPDR MSCI Europe UCITS ETF (ERO), managed by State Street Global Advisors (SPDR) and traded on the NYSE-Euronext.

Conclusion

An index fund is simply a mutual fund that, instead of having a portfolio manager making the selections, commits the capital allocation to the individual or committee that determines the index methodology.

Choosing investments is not easy. Both mutual funds and index funds are convenient options with potential to grow.

Index funds, however, have some more advantages especially for modest portfolios:

• Opportunity to participate in any market the fund represents with a single purchase, which means low transaction costs;
• High passivity, meaning that you don’t have to worry about methodology changes and have much better tax planning flexibility in case you need to raise cash;
• Build a good foundation underneath you by investing just small amounts of money;
• Index funds are already diversified by nature, which reduces company-specific risk;

By choosing good indices, your investments will likely result to yield good returns with little investor effort.

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