Investing In Index Funds versus Managed Investment Funds

 

 

 One of the major discussions in the investment world is about whether investment funds for investment funds generally add value for investors. Since Vanguard introduced the first index fund in the 1970s, skeptics and critics of the financial services industry have argued that professional money managers have failed to earn their money. If they are all taken together, they simply do nothing better than a random selection of securities in a certain market or investment style.

Nonsense, claim investment companies. There are many managers who have shown that they can surpass a random selection of securities even after deducting their costs – you just need to know how to identify them. In addition, an active manager can offer benefits that an arbitrary basket of securities cannot: An active manager can hold more cash when things look ugly, or put a bad news out of business by selling before the whole thing collapses. Indexers, on the other hand, must take the bus off the cliff.

Who is right? Well, if you have to ask, it’s time to go back to basics and see how investment funds – including index funds – are designed and built. You must also view some of the most important statistics.

As with so many aspects of investing, context counts and there is often a time and place for both approaches.

What is an investment fund?

 

An investment fund is simply a scheme whereby a group of investors pool their money and hire a professional money manager to buy and sell securities on their behalf. The typical arrangement is that the money manager (or his company) takes an annual investment cost from the assets of the fund, usually between 0, 5% and 1, 5%. This is called a cost ratio and comes directly from your account as part of your assets.

The investment company takes this money and uses it to pay overheads, office costs and marketing and to pay a depositary to settle transactions. The money also pays a salary to the fund manager and a team of analysts who help the fund manager to buy and sell shares, bonds and other securities. When you have a manager (or team of managers) who actively buys and sells selected securities to maximize returns, minimize risk, or both, that approach is called active management.

But what if you didn’t have to pay a team of analysts to sit all day and analyze effects? Can you pay a lower cost ratio? It appears that you can do that through a special type of investment fund, an index fund.

 

What is an index fund

 

Index funds are still investment funds, whereby you bundle your money with other investors. And you still have an investment company that handles your transactions. The difference is that the investment company does not pay a fund manager and a team of analysts to try to select stocks and bonds. Instead, the fund eliminates intermediaries, saves investors their salaries and simply buys everything in the specific index it wants to replicate. This index can, for example, track stocks, bonds or REITs.

What is an index?

What is an index?

An index is an unmanaged collection of securities designed to display the characteristics, returns and risk parameters of a specific segment of the market. An index is a theoretical concept: you cannot buy shares directly in an index, but you can buy shares of the companies included in the index.

The best-known index, for example, is probably the Standard & Poor’s 500 index of large-cap stocks. This index is simply the largest 500 US companies traded on the New York Stock Exchange, measured by their market capitalization, or the total value of all their shares.

The index itself is weighted by market capitalization, which means that the index contains more shares of larger companies. Larger companies therefore have a greater effect on the return of index funds than smaller companies.

How does it work? It’s simple: an investment company starts an index fund and wants the fund to follow the S&P 500. So they collect money and use the money to buy an equal percentage from every company in the index. This share will be small – there are many other people who already own each company, so they will usually buy something from 0.001% of each company in the index. Investors do not own the index directly, but own shares in this fund, which theoretically closely monitor the performance of the index, minus the amount of their costs.

Note that there is no role for the analyst here – and all fund managers ensure that the fund keeps the securities in the index at all times. He is not trying to beat the index; it simply ensures that the portfolio matches the index as closely as possible. This approach is called passive management.

General indexes

Investors are of course not limited to the S&P 500 index for their index investment. There are hundreds of different indexes to choose from, and many investors use them in combination with each other.

Other commonly used indexes include:

  • The Russell 2000 follows American smallcaps.
  • The Wilshire 5000 seeks to track the entire universe of stocks that are publicly traded on the NYSE.
  • MSCI EAFE follows the largest companies in the European markets.
  • MSCI Emerging Market follows the stock markets in various emerging economies, such as Southeast Asia, Africa, South America and Central America.
  • Barclays Capital Aggregate Bond Index follows the universe of listed bonds, including government bonds, corporate bonds and high-yield bonds.
  • NASDAQ 100 is an index of the 100 largest companies whose shares are traded on the NASDAQ. This index is also a large-cap index, such as the S & P 500, but is much heavier for technology.
  • Nikkei 225 is an index that tracks the largest Japanese companies.
  • MSCI US REIT Index tracks the performance of the largest listed real estate investment funds in the US.

There are indexes that track almost every country in the world, most regions, and most asset classes. The US market represents slightly less than half the total market value of shares traded around the world. Many investors would like a significant Caribbean exposure to US equities, but also have a counterweight to exposure to European equities, Asian equities, emerging markets, REITs, and bonds. Part or all of this can be achieved by owning index funds.

 

Does index investing work?

Does index investing work?

 

Over the years, indexing has proven to be an effective strategy for many small investors. This is the theoretical foundation behind the logic of indexing as a strategy:

benefits

  1. Markets are efficient . The indexer believes in principle that the market as a whole is very good at quickly pricing all available information about a share or market in the market price (ie efficient market hypothesis). It is therefore almost impossible for a particular money manager to consistently outperform the market over a long period.
  2. It is very difficult to identify managers of the winning fund in advance . Go back in time and view the returns of the best fund managers every year. In the vast majority of cases, a fund manager will fly high for a year or two in a market trend. But after the markets take their course, another investment style becomes popular and last year’s heroes are this year’s goats. The indexer thinks it is not worth guessing who will be the best performing manager this year.
  3. Investment fund managers cannot add reliable value beyond their costs . The advocate of passive management is of the opinion that total investment fund managers and other institutional investors cannot reliably beat the market. Why? Because together they form the market. They are therefore anything but doomed to assume a well-constructed index with approximately the amount of their costs.
  4. Index funds have lower sales . It costs money to churn – or excessively trade – securities in your portfolio. Investment funds must pay brokers and traders and must also include the hidden costs of bid-late spreads every time they trade. The bid-ask spread is the difference between what a stock trader pays for the shares and for which they sell them. Brokerage companies identify the overlap between what investors are willing to pay for a security and what investors are willing to sell a security for, and make part of their money by cashing in the difference. The more a fund trades, the higher these costs. But index funds never have to trade, except when new securities are added to the index, or to buy or sell just enough to cover fund flows that come in and disappear when investors buy or sell. (Closed-end fund or ETF, managers do not have these concerns.)
  5. Index funds are tax efficient . Index funds are generally tax efficient, thanks to their low turnover. This is important because every time an investment fund sells a company with a profit, it has to pass on that profit to its shareholders, who pay capital gains taxes on that profit. This is irrelevant for funds held in retirement accounts, such as an IRA or 401,000, but it is an important consideration for investment funds that are excluded from the retirement accounts. For this reason, index funds are popular choices for use in taxable (non-retirement) accounts.

Performance

Because of these built-in structural benefits, it would be expected that index funds routinely outperform the median performance of actively managed funds that invest in the same category. Index funds cannot beat the index, but because they approach the return of the index while minimizing spending, the lower spending should give index funds a noticeable benefit. We do not expect a low-cost index fund to find itself in the lower half of the universe of investment funds with a similar investment style for a long time.

So what do we find? Let’s look at the return of the Vanguard 500, the original and one of the most used index funds, which follows the S&P 500. We will use the investor share class, which is the non-institutional variety and the fund that is the most investor. can actually invest in.

1. Equity funds
From January 23, 2012, the Vanguard 500 fund is firmly in the upper half of all mixed colors (balance between growth and value style) that Morningstar follows. This is true regardless of whether you look at the 10-year, 5-year or 1-year track records, where the fund records percentile ratings of 41, 33, 28 and 19, respectively. (With percentile rankings, low numbers are good and high numbers are bad. A “1” means that the fund is in the top 1%, while a “99” means that the fund is in the bottom 1%, slightly less than “50” means that the fund outperformed the median.)

Does the strategy transfer to bonds? Let’s see:

2. Bond funds
As of January 23, 2012, the Vanguard Total Bond Market Index, now following the Barclays Capital Aggregate Bond Index, published 10, 5-year, 3-year and 1-year return rates of 44, 36, 83, and 15, respectively. Most of the fund was successful in outperforming the median bond fund, but not as consistent as the S&P 500 tracking counterparty. In both cases, managers have been quite successful in tracking their indexes, leaving them behind in the last 10 years with amounts that were roughly the same as their costs.

That is roughly what you would expect, because indices, as theoretical constructions, have no costs. Only real investment funds have costs and indexers simply try to minimize those costs.

 

The Warren Buffett counter argument

 

Warren Buffett, the chairman of Berkshire Hathaway and one of the most successful value investors, rejects the logic of efficient markets. It is easy to understand why: he earned his fortune – and the fate of many other people – by buying shares at a discount for their intrinsic value. Quite simply, he looks for stocks that estimate markets unfairly low, precisely because efficient market theory does not persist in all cases in a long run. According to him, he has been successful many times in finding stocks that sold 30%, 40% or even 60% off their real value. “I would be a bum on the street with a tin cup if the markets were efficient!” He once told investors.

The disadvantage of this approach to investing is of course that it takes a lot of time and often leads to very limited portfolios, which can lead to more volatility. Not every investor can take the time to pursue the Buffett approach, even if he had his vast knowledge of accounting and business experience – which brings you back when choosing an investment fund and deciding whether you want to pay a manager a percentage for securities choose for you, or if you want to keep the fee and invest, instead of paying it to the manager.

For most people who do not have the time and expertise to dig deep into the analysis and research, Buffet even recommends the indexing approach.

Last word

 

Of course, investment companies defend their competitive position grimly. They earn a lot of money from people who hire active managers. And some managers have been able to add value for investors on top of their costs in cost ratios and costs. In fact, active proponents of management argue that it is not logical to compare index funds with the average fund, because it is possible to identify stronger managers in advance. For example, you can limit your analysis to active fund managers with a mandate of at least 5 or 10 years and lower cost ratios.

And the debate goes on and on. To determine which approach you prefer, you start by assessing your needs and what you are investing for. For example, will capital gains be a problem – are you investing in or outside of a pension account? And are you willing to investigate investment funds from investment funds to determine what benefits can be gained over their relative index?

View the benefits of indexing above and see if they make sense to you. If you still can’t find out, invest in both and let the experience be your guide.

 

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