Canto 9

Index Funds

In all the categories of funds we've talked about so far (mutual funds and ETFs, RRSPs and TFSAs, stock funds, bond funds, etc.) there are funds that are called index funds. In most of these categories there are also actively managed funds. So what's the difference?

First, What the Heck is an Index?

There are a wide variety of market indices out there, to measure how well different markets are doing. For example, there's a thing called the S&P 500 Index. A company called Standard and Poors (S&P) maintains a list of the 500 largest companies traded on the US stock exchanges. Largest is measured based on the number of shares that exist multiplied by the current value of those shares on the market. So these are 500 really big companies. In their calculation, they include a number of shares for each company that will make its percentage of the index proportional to its market size. Since the value of the individual shares is constantly changing, so is the value of the index as a whole. They've been making these calculations for these 500 companies since 1957 (and they've had other indices since even before that). Of course, the companies in the index aren't the same as they were in 1957. For example, if two companies merge, then there are only 499 companies, so they have to add another one at the bottom. I guess if a company split in two and became two companies that were both big enough to be in the index, they'd have to knock one out. People pay attention to the value of the S&P 500 index because it's a pretty good measure of how well the stocks of big American companies are doing on average.

There are other indices that track even smaller groups of companies (like the Dow Jones Industrial Average, which has existed since 1896 and tracks 30 large companies). There are others that track medium sized companies or small companies, or even the entire stock market. There are indices that track the bond market, or different parts of the bond market. There are indices that track the markets in Canada, the UK, France, Germany, and every other country that has a stock market. There are indices that track groups of these countries, like Europe or Latin America. There are indices for particular sectors of the market, like technology or health care. Seriously, the Wikipedia list of market indices goes on for pages and pages. If you can think of a way you could subdivide the market, someone has probably made an index for that. And the someone is generally some kind of independent firm of market analysts who make their living doing that kind of stuff.

Index Funds versus Actively Managed Funds

In an actively managed index fund, there is a manager or a team of managers who study the market and decide what things to buy and sell. If a bunch of people like you decide to put more money into their fund, they have to decide what securities to buy with that money. There will be a plan for the fund, laid out in its prospectus, that determines what sorts of things they are supposed to buy. For example, if the prospectus says the fund is supposed to invest in Canadian corporate bonds, the management team won't go out and buy stocks in some Brazilian mining firm with your new money (or they can be fired). But within the limits of what's laid out in the investment scheme in the prospectus, they are supposed to study the various securities available to them, try to predict what things are going to do well, and buy and sell stuff on that basis.

An index fund is pretty different. An index fund holds the securities that are part of a market index. The company that manages the fund is just trying to slavishly follow the list of securities that are in the index, and hold them in the same proportion as the index indicates. For example, if you buy shares in a mutual fund that says it tries to match the S&P 500, your new money should be used to buy new shares in the companies listed in that index. The people who manage the fund don't have to do any research, because they can just get the information from Standard and Poors listing which companies they are supposed to own. They hardly have to buy and sell things (except when investors give them new money or take money out), because the shares in the index change only very slowly, and usually only around the bottom of the index.

Why are Index Funds Good?

Index funds are good mostly because they are cheap. Since the management team doesn't have to do any research, or engage in much deep thought, they don't have to be high-flying financial experts with yachts and expensive luxury automobiles. As long as they are competent to handle the buying and selling, manage the accounts of their investors, file taxes on time, and basic stuff like that, they can manage an index fund. That means the percentage of your money that goes into management fees is generally a lot lower. In the US, sometimes it can be *really* low. For example, some bond funds in the US charge as little as 70 cents per year for every $1,000 you have in there. That's in contrast to some actively managed stock funds, where the managers can charge people $30 for every $1,000 or sometimes even more.

I'll be devoting a whole article to the costs of mutual funds, so I won't go further with that now, but what else is good about index funds? One thing is that it encourages you to park your investments for the long term and not think about them too much. The thing is that if your mutual fund or ETF is going to just slavishly follow the index (minus a very small annual fee), you don't really have to worry about whether you've made the right choice of funds. It's not going to outperform the market, but it's not going to underperform it by much either. If you put your money in an actively managed fund and it does well compared to the market, that's great, but if it starts to slump compared to the market (as they all do eventually), you'll start worrying about whether you made the right choice.

When are Actively Managed Funds Worthwhile?

I think actively managed funds have a role to play in markets that are not well-understood. When you're talking about the 500 biggest publicly-traded companies in the US, there is huge information available to investors. By law, they have to reveal information about their finances and operations on a certain schedule, and everyone gets access to it. Nobody gets much of an information advantage over anyone else in trading these companies. This is sometimes called an "efficient" market. I think markets like that are where an index fund makes the most sense.

In markets for very small companies, or in some overseas markets, the information is sometimes scarce and sometimes unreliable. Markets like that are sometimes called "inefficient" markets. I think in those cases an active management team can find out things that other people might not know, and therefore might make better decisions about which securities to buy and sell.

In other cases, the index has so many companies in it (some of the small company indices have thousands) that it's not really practical for a fund to own them all. In those cases, there may also be a role for active management in selecting the subset of companies the fund will own.

So which should you choose?

I think in general the core of an investment portfolio should be index funds. Actively managed funds should be used selectively to invest in inefficient markets.

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