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Finer Points

What You Need to Know Before Investing in Index Funds

02/15/2019

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First-time investors may be interested in learning more about index mutual funds, as index funds have exploded over the last several years and become a very popular place to put investment capital.
This article will outline everything that you need to know about investing in index funds, offering some pros and cons, as well as some strategies for better, smarter index investment.
Read on to learn more.

What Exactly are Index Funds?

Index funds present an interesting opportunity for novice and first-time investors, as they allow an investor to buy into a diverse group of industries, sectors, and stocks without overinvesting in a single individual equity.

Investing in index funds or mutual funds can be a great strategy, as indexing by definition uses the first principle of investment: diversification.

Some of the other advantages of investing in index funds include relatively-low management fees and associated expenses, minimal portfolio turnover, and of course exposure to a very wide number of commodities and industries.

As far as equity investment goes, index funds may be a pretty safe play, as they do not come with many of the risks inherent to investing in an individual equity. By buying into an index, you are investing in a fund that tracks the market itself, which over time is almost assured of growing and producing a return on your investment.

Why Invest in an Index Fund?

Index funds are not new, with the Vanguard 500 index mutual fund opening in 1976. That said, index funds remain an extremely-popular investment options for a number of reasons.

To use the Vanguard 500 as an example, like any large index fund, it exposes investors to the vast majority of the U.S. stock market. Investors are buying into such diverse sectors as health care, materials and fabrication, real estate, and consumer goods, putting their investment eggs into a large number of different baskets.

As the name suggests, the Vanguard 500 collects 500 of the biggest companies in the United States, cutting across a multitude of industry and accounting for about 75% of the U.S. stock market’s aggregate value.

As with any equity investment, the Vanguard 500 is subject to volatility, but by investing in so many proven stocks spanning so many numerous sectors, investing in index funds like the Vanguard 500 is generally less risky than placing the bulk of your investment capital into a single stock.

Index funds are also passively-managed, which significantly cuts down on associated management fees. This makes investing in index funds a lower-cost – and potentially lower-stress – alternative to active equity trading.

Rather than always trying to beat the market by timing investments, indexing works by investing in the market itself. By investing in so many different sectors and industries, an index fund largely mitigates the risk of a complete market collapse or a single stock going belly-up.

As noted above, indexing has become a very popular alternative to buying into individual stocks. As of this writing, there are currently 1,732 index portfolios, which a massive increase from the 400 or so index funds that were available just ten years ago.

For frame of reference, assets in stock index funds have ballooned over 70% since 2013, while the cash collectively held in index funds has doubled.

Meanwhile, actively-managed stocks have not fared nearly as well. Capital investment in U.S. stock portfolio has dropped almost 20% within the same timeframe.

It’s clear that many investors are eschewing individual equity investment in lieu of indexing, as a lot of investors would prefer to not chase gains so aggressively and prefer to let the market do the work for them.

That said, before an investor commits to a given index, they should carefully consider the quality of the index, as quality has often has the most direct bearing on yield and long-term returns.

The Importance of Index Quality

Quality should be a primary concern when selecting an index fund or funds to invest in. Not all index funds perform equally over the long run, and like any other asset or equity, an investor should consider an index’s performance over both the short and long-term prior to investment.

Index quality can be measured in a number of different ways. A few of the ways in which index quality can be measured include consistent returns on equity, low debt-to-equity ratios, and stable (or ideally, increasing) annual earnings. All of these are quantitative ways in which index quality can be measured.

Qualitative ways of gauging index quality include sustained track records of management performance and solid corporate governance, as both of these qualities help instill additional confidence in investors and contribute to better long-term performance.

Company quality isn’t considered as strongly when the market is booming, but companies with strong leadership and infrastructure become much more valuable during times of market stress or decline.

Traditionally, investors have jumped ship from stocks that have made their gains with higher risk-taking and without factoring quality. Downturns inspire investors to go back to steadier, more proven indices and to place a premium on intangibles such as steady leadership.

Accounting for quality is active risk management, and generally higher-quality companies have upside capture ratios that surpass their downside capture.

These attributes allow investors to keep more of their earnings over time via compounding, which isn’t the case when one invests in lower-quality, more volatile companies.

In short, investing in index funds becomes a lot simpler – as well as a lot more profitable – when an investor accounts for quality initially, rather than going with a lower-quality alternative riding a high wave.

Choosing the Best Index Funds

As explained above, the popularity of index funds has exploded in the last several years. There are more options than ever before for investing in index funds, and the choices can frankly be overwhelming.

Going with one of the largest and most-established funds, such as the Vanguard 500, is likely a good choice. The Vanguard 500 (VFINX) mirrors the S&P500, and has done better than all but the top 20% of U.S. stocks since 2015.

That said, there are a number of great options for investing in index funds, and it’s incumbent on any investor to better investigate all of the options in the interest of improving long-term returns.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

We agree with many long-term academic studies that continue to validate the importance of how quality earnings are directly connected to real equity performance…

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Finer Points

What You Need to Know Before Investing in Index Funds

First-time investors may be interested in learning more about index mutual funds, as index funds have exploded over the last several years and become a very popular place to put investment capital. This article will outline everything that you need to know about investing in index funds, offering some pros and cons, as well as […]

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