Updated Feb, 2020

Index funds

index bar graph

The “index” refers to the entire investable market in proportions to their company valuations.
So if CBA (Commonwealth Bank) is valued at double BHP, it would be valued at double in the index and similarly for all companies.

An Australian index contains all the stocks in the Australian market in their valuation proportions.
An emerging market index contains all the investable stocks in the 23 emerging countries in their valuation proportions.
A developed countries index contains all the stocks in the 23 developed countries in their valuation proportions.
You get the idea.

Investing in an index allows you to say

I don’t know anything about choosing a company, sector, country, or anything else, and I also don’t know how to choose a fund manager capable of choosing them. I accept that I don’t know. But I still need to invest for my future.

Investing in an index fund allows you to invest in the entire market without the risk of you or anyone else selecting the wrong stocks by just buying everything.

Important points about index funds

1. Fees

Before index funds were available, if you had no idea how to pick stocks to invest in, your only option was to invest with active managers.
They generally charged around 2% of your total assets invested with them each year for picking their stocks for you.

Let’s take a look at the numbers.

The long-term return for Australia and the US has been 6% over inflation.
2% in fees means you have lost a third of your return.

And compounding works both ways – the longer you compound gains, the more of a positive effect compounding has, but the longer you compound losses, the more of an effect compounding has on your returns, but in the other direction.

Let’s look at the effect after 40 years of compounding on a $100,000 investment.

The first with 2% management fees taken out. The second at 0.2% management fees of index funds taken out.

$100,000 for 40 years at 4% compounded annually = $480,102
$100,000 for 40 years at 5.8% compounded annually = $953,732

Those fees cost you half your net worth. When it comes to fund management fees, 2% is an enormous amount. Even 1% is nowhere near acceptable, as you can see in the chart below. At the 10 year mark, you can get an estimate of your costs by multiplying the expense ratio by ten, and it just gets worse after that.

cost of investment fees over time

2. Performance

With index funds, you’re guaranteed the performance of the entire index.

You might think that fund managers can pick better performing stocks so you can get a return that makes up for the fee and more, but the data is out on this. S&P has been tracking active management performance for a long time now and release regular SPIVA reports. Their findings are that while over any 1 or 2 year period, an active manager may outperform the index, over 15+ years, more than 80% of active managers fail even to match the index after fees.

This can be explained by the Pareto Principle (the 80/20 rule).
Most of the future performance will come from a disproportionately small number of companies in the market, and it’s much easier to miss some of these few companies resulting in lower returns than just investing in everything. As a consequence, a disproportionately small number of fund managers outperform by a large magnitude, and a disproportionately large number of fund managers underperform. So when you pick a fund manager with no real idea where they will end up, you have a much higher chance (over 80% going by the SPIVA reports) of ending up with one that underperforms.

And while there are some actively managed funds that outperform, the probability of identifying them ahead of time is very low. Not many people knew in 1960 that Warren from Omaha, Nebraska, was going to deliver stunning returns, and he only became famous once most of his stunning returns had already been delivered.

3. Fund Manager Risk

Fund managers can and do make mistakes in their investment choices. Just today, I read another article about a fund manager who the BBC once described as “The man who can’t stop making money”. He messed up so badly, with billions of investors’ dollars in funds, that they had to “gate the fund” to stop investors taking out their own money to avoid a fire sale (selling below value to pay out investors), causing massive losses to his investors.

All investors in the market are made up of a combination of index investors and actively managed funds. The index investors are, by definition, getting the market return. So when we look at the average of all funds collectively under active management, the performance will also be that of the market (minus fees) – because if you could pick which managers will outperform, we would all pick those. When you go with active management, you get the same expected return as indexing, but you now have additional risk. Why take a risk without a reward?

For those who argue that you can outperform by picking an active manager, the problem is that since you can’t know in advance which funds will outperform and which will underperform, you’re not increasing your expected return. What you’re doing is increasing the range of possible outcomes (which is the definition of risk) without increasing the expected return, which is the definition of gambling.

Imagine a game of roulette. 1 in 37 times you get 37 times your original bet, and the other 36 times you get nothing, so your expected return is (37 x bet + 36 x 0)/37 = your original bet. Your expected return equals your original bet, but you’re hoping that it will land in the higher end of that larger range of outcomes, but hope is not an investment strategy. This is the difference between gambling and investing.

4. Idiosyncratic risk

Idiosyncratic risk is the risk of buying a single stock or a single sector of stocks, or a single country’s stocks.

Let’s say you expect a company to fail, on average, 5% of the time.

If you invest in 1 company, you have a 5% chance of a complete loss of capital.

If you invest in thousands of companies, there’s no chance that all companies will fail. Instead, you will get much closer to your expected return of a 5% loss of capital. Compensated by the profits of the other 95%, you wouldn’t even notice it.

What about blue chip companies – they’re too big to fail, they’ll always land on their feet.

Are you sure? What about Xerox? And Polaroid? Kodak? Nokia, Blackberry, Control Data, Nortel, Worldcom, Palm, Blockbuster, Burroughs, Reader’s Digest, Digital Equipment Corporation, Schlitz, Enron, General Motors, General Electric, …

So if we go back to the risk-reward spectrum in the previous article, we can see that with diversification, you’re getting the same expected return but with lower risk, i.e. a lower range of possible outcomes.

What this means is that diversification is a free lunch – an upside with no corresponding downside.
It goes the other way too – idiosyncratic risk, just like fund manager risk, is a risk without a reward – it’s a silly risk to take when you think about it.

When you invest in just one company, one sector, or one country, you’re taking an uncompensated risk.

The take-home message is to diversify broadly.

Index funds are the cheapest and most efficient way to diversify broadly to mitigate idiosyncratic risk.

Further reading

The case for low-cost index-fund investing – Vanguard
10 Reasons I Invest in Index Funds – The White Coat Investor