Thursday, June 29, 2017

Index Funds?

What are index funds and should you invest in them?

A few years back, a reader wrote that I should look into index funds.  And I did and bought some shares in a couple of them.  What are index funds?  They are just mutual funds - that follow some stock index.   There are a plethora of mutual funds out there, investing in everything from stocks to bonds, to government bonds, to whatever.   And each fund usually has some sort of goal or strategy.  Small Cap, Large Cap, foreign bonds, US bonds, Municipal Bonds, tech stocks, energy stocks, income stocks, or whatever.

And each fund has a fund manager or managers who manage the fund and decide what to invest in.  And for the most part, you have no idea on what they are investing in, on a day-to-day basis.   You can sort of get an idea from the prospectus and annual report, but you don't know what they are buying and selling in real-time.   You are leaving it to an expert to make sound decisions, and he generally gets paid more for making better decisions, so his interests are aligned with yours.

Compare this to hedge funds, where the managers get paid a percentage of the fund balance regardless of whether they make money or not.   You can understand why people are fleeing hedge funds these days - the overhead is high and the returns in recent years are not as attractive.

Mutual funds may have front-end loads or back-end loads or they may be no-load.   For a typical "load" fund may have to pay a fee upfront (deducted from your investment) when you invest, and often this fee goes in part to the salesman who sold you the fund.  Yes, that friendly "investment advisor" isn't working for oxygen, he needs food on his table.  And that is why, when you, as a young person, go to a "storefront" investment advisor (and you know exactly which one I am talking about - coming to a strip mall near you!) they really aren't interested in talking to you unless you have at least $10,000 to invest - so they can make $500 "advising" you which mutual funds to invest in.   If you are just starting out in investing, well, go fuck yourself.   Come back when you got some real money, kid!  (Or at least that was my experience when I was in my 20's).

Some funds have fees (back end loads) you have to pay when you sell shares in the fund.  The idea here is to encourage you to invest for the long haul, rather than trade. So they penalize you when you decide to sell.   And some funds are "no load" which seems to defy gravity.  How does a mutual fund company make money if they are not charging a fee?  Volume?  No, they have something called an expense ratio that they charge to the fund every year.  You don't see this as a line-item on your statement, but it is buried in the annual report somewhere if you look for it.  And no, the friendly storefront investment advisor doesn't mention it unless you ask, and even then....

And let me just say right here that I was invested in mutual funds for well over a decade before I understood any of this.   And yes, I had investment "advisors" tell me I was investing in a "no load" fund which turned out to have a 5% front-end load, of which the advisor got half.   When rolling over a 401(k) or IRA, be particularly aware of this.  You might, after a few years of hard work, accumulate $100,000 or more in your 401(k).   Your friendly "investment advisor" will suggest you roll this over when you leave the company.   And if you are not careful, he may skim 5% off the top when you move the funds to his company - as a State Farm rep once tried to do with me.

It seems that no matter what investment house you use, they want you to "roll over" your investments to their little playpen, and usually there is a reason for this - a monetary reason.   Caveat Emptor.

But there are "no load" funds out there, and these funds make their money for their managers through the expense ratio fees.  And some funds charge a lot, and some charge a little.  Vanguard has a lot of low expense ratio funds.  And of these, index funds usually have the lowest expense ratios.  Why?  Well an index fund, as the name implies, invests in a "market basket" of stocks that correspond to some market index, such as the Dow Jones Industrial Average (DJIA), the S&P 500, the NASDAQ Composite, or the like.

What are these indexes?  Well, that is the funny thing.  When people say "the stock market went up" or "the stock market went down" they are not talking about the entire market but an index instead.  The DJIA, for example, tries to measure the health of the market using a collection ("market basket") of stocks, usually "blue chip" type stocks.  And who is on this list of stocks and who is not, changes over time.  So in essence, the Dow, Jones people are "managing" your fund by determining what stocks are in the DJIA.   Your management company merely buys these stocks, takes a small, small cut as the expense ratio (like 0.15%) and then pays you the rest.

The advantages touted by such funds are many.   These indexes seem to go up over time far more than many "managed" investments.   People say if you just followed "The Dow" you'd make out better than most prognosticators, over time.   And since the expense ratios are tiny, you don't waste a lot of money on overhead costs.   For the mutual fund company, the costs are low, as a computer can basically trade the stocks automatically, as each person buys into the fund or sells out.

For example, Vanguard Total Stock Market Index Fund, states its goals as follows:
The Fund seeks to track the performance of a benchmark index that measures the investment return of the overall stock market. The Fund employs a "passive management" approach designed to track the performance of the CRSP US Total Market Index.
So in this case, the "index" is the "US Total Market Index" as determined by the Center for Research in Security Prices (CRSP).   This is an index that actually tries to track the overall market.   How does the fund perform?  What are they invested in ?   Well our friends at Morningstar (who I thought made breakfast sausages, but I was mistaken) have some data on this:

Performance  VTSMX More...

YTD 1 Mo 1 Yr
3 Yr  * 5 Yr  * 10 Yr  *

Growth of 10,000 10,970 10,142 12,299
Fund 9.70 1.42 22.99
+/- S&P 500 TR USD -0.42 0.22 0.59
+/- Category 0.40 0.21 1.36
% Rank in Cat 44 32 35
# of Funds in Cat 1,431 1,495 1,358
* Annualized returns.
Data as of 06/28/2017. Currency is displayed in USD.

Top Holdings  VTSMX More...

Weight % Last Price Day Chg % 52-Week Range

Apple Inc 3.00 144.57 -0.88
93.63 - 156.65

Microsoft Corp 2.02 68.98 -1.15
49.80 - 72.89 Inc 1.59 981.77 -0.84
710.10 - 1017.00

Facebook Inc A 1.41 151.34 -1.23
112.97 - 156.50

Johnson & Johnson 1.38 133.13 -0.50
109.32 - 137.00

% Assets in Top 5 Holdings 9.40

What is a little scary to me about index funds is that these indexes tend to include popular and trendy stocks. I would not buy Facebook stock on a dare, but since I am invested in mutual funds, I end up owning some of it, although only 1.41% of the overall fund.

Should you invest in an index fund? Sure, why not. But not as the only thing you invest in. Odds are, at your place of work, if you have a 401(k), one of the choices of funds to invest in, is an index fund. I would not put all my eggs into one fund basket, though, as indexes do go down over time.

Which are the best funds? Well, it depends on who you ask, and when. "Investorplace" has a list of the 7 best funds, but they also have a list of 10. Kiplinger has a list of "only five" funds you need to know about. Even Motley Fool has a list. Odds are, your investment house has some of their own funds. Fidelity and Vanguard have them, I am sure Merrill does as well. The real decision to make is which index to use and who has the lowest expense ratios. It goes without saying that paying a "load" on an index fund is sort of pointless. It is not like they are advising you or trading your shares.

The advantages are many. It sort of puts your investments on auto-pilot. The market goes up, you make money. It goes down, you lose with everyone else (unless your particular index outperforms the overall market). You don't have to worry about traders churning your account down to zero by making crappy trades. It is a pretty brainless form of investing.

But for the most part, it is a risk-taking venture, and unless your index fund is indexed on a government bond index or something, you can lose money. So putting all your eggs into the index-fund basket is, in my opinion, a bad idea.