Are you looking to grow your money easily and affordably? Well, index funds may be right for you. In this guide, we’ll cover the basics of investing in index funds before diving into the interview portion with Mark Hebner. To skip to it right away, use the links below.
- What is an Index Fund?
- The Benefits of Index Funds
- The Drawbacks of Index Funds
- How to Invest in Index Funds
- Q and A with Mark Hebner
What is an Index Fund?
Index funds are a type of mutual fund or exchange-traded fund (ETF) that are made up of a variety of stocks. Generally, they’re affordable, less risky, and a good investment for beginners. Additionally, you’ll likely experience a slow, yet the solid return of investment. Low-fee index funds are index funds because of the way they’re managed. For example, a team isn’t keeping a close eye on it to make market predictions. And in some cases, your portfolio is managed completely by AI software.
Benefits of Index Funds
Most people invest in index funds due to portfolio diversification, low costs, and a solid return. We’ll take a closer look at each reason below.
Investing in an index fund means having a diverse portfolio with minimal risk. For instance, the S&P 500 index fund, which is one of the most well-known index funds, is composed of 500 established companies, including Apple, Tesla, Facebook, Microsoft, and more. With a well-rounded portfolio, you won’t be putting all your money into one stock. This keeps your investments safer in case one of the companies you’re invested in starts doing poorly.
When you invest in an index fund, you typically must pay an expense ratio, which is an annual fee based on the total amount that you’ve invested. Because index funds are passively managed, this expense ratio can range from .03% to .05%, which is much lower than actively managed funds that have a yearly expense ratio of 1% or 2%. In the long run, this could mean huge savings for you.
Most of the time, an index fund will outperform an actively managed mutual fund. This is usually due to human interference. An active fund manager could make a poor decision, causing you to lose money. However, betting in the slow and steady growth of the market is usually a fairly safe bet.
Disadvantages of Index Funds
At the end of the day, index funds are still an investment, meaning no matter how minimal the risk may be, there’s still a chance you could lose money.
Index funds are passively managed, which leaves room for vulnerabilities. An active mutual fund has a team actively looking at the stock index for trends and could liquidate assets before shareholders experience a hit. 2020 was an extremely volatile year, and while index funds are considered safe, they still faced plenty of losses.
Lack of Flexibility
The lack of flexibility may push some investors away from index funds. Index fund managers have certain policies they must strictly adhere to. So, if an index is on the decline, there’s only so much fund managers would be able to do.
Forget about Getting Rich Quick
If you think you’re going to become the next Warren Buffett by investing in an index fund, you may want to reconsider that thought. Since your money is spread out among various stocks, a rapid incline in one of them won’t change the value of your investment overnight.
How to Invest in Index Funds
1.Pick Which Index
As mentioned, one of the best-known indexes is the S&P 500. However, there are others, such as the
- Bloomberg Barclays US Aggregate Bond Index
- Dow Jones Industrial Average (DJIA)
- Fidelity 500 Index Fund
- MSCI EAFE
- Nasdaq Composite
- Russell 200
The index you decide on depends on your investment experience and strategy. Before you decide, look at how it’s performed in the past. Ideally, you’re looking for a total stock market index that has been consistent while experiencing growth.
2.Select Your Desired Index Fund
Once you’ve decided on an index, you have to find the best index fund that tracks it. For indexes, you’ll have plenty of options to choose from. To narrow it down, keep in mind the following questions:
- What’s the expense ratio?
- Is there an account minimum and minimum investment you should be aware of?
- Which investment fund has the lowest costs?
- Are there any restrictions placed on the index fund?
3.Decide Where You Want to Buy
To start investing, you can purchase an index fund via a brokerage firm or mutual fund provider. There are many aspects you should take into consideration before you purchase, such as overall costs, convenience, and fund variety.
If you want a more in-depth guide on how to invest in the stock market or want to learn how the stock market index works, check out our investment blogs. Keep reading for our one-on-one interview with Mark T. Hebner, author of Index Funds: The 12-Step Recovery Program for Active Investors and founder and president of Index Funds Advisors (www.ifa.com).
Q and A with Mark Hebner
Why should investors choose index funds over actively managed funds?
“I actually started off with the idea that active investing is really a little bit of a gambling addiction for investors, and therefore they should go through my 12-Step Recovery Program for active investors, which basically dismantles the whole idea of active investing and describes a more prudent passive investing strategy.”
According to a study by Professors Barras, Scalliet, and Werners, 99.4% of 2,076 mutual fund managers displayed no evidence of genuine stock-picking skill over a 32-year period from 1975 to 2006. The remaining 0.6% who did outperform the index were “statistically indistinguishable from zero.” Or as Mark Hulbert put it, “just lucky.”
And yet, investors pour money into actively managed funds. Why is that?
“At the end of the day, one of the reasons you would pick an active manager is you believe he’s going to provide an alpha—excess return for a fund relative to its appropriate benchmark.
What this study says is that it’s rare for managers to beat their benchmark every year. What you discover is some years they do better; some years they do worse. On average, they may be positive but the more their returns vary, the more likely it’s due to chance.
If you don’t believe what I’m saying, carefully read the study. If you understand it, you will never again pay a fund manager 3 to 10 times what you pay for an index fund.”
But fund managers seem to always be touting how they beat their benchmark. Are they misrepresenting their results?
“One of the main reasons active managers appear to be beating a benchmark is because the wrong benchmark has been selected, number one.
Number two, they style drift throughout their history so that a more appropriate benchmark would be a moving benchmark, where one year might be closer to large growth and the next year closer to a large value, and so on.
The missing link in all investment analysis is proper benchmarking.”
What’s your evidence for that?
“We did a study of 614 mutual funds over 10 years, and only 0.16% of them—basically one—had a return that beat what’s called a “multiple regression benchmark.”
Beyond these two studies, there are probably 100 different studies that come to similar conclusions in different ways. That’s why I would never pay a manager to actively manage my portfolio.”
But what about investors like George Soros who appear to generate alpha consistently over time?
“One second. Give me the standard deviation of the alpha; how volatile are his excess returns, his alpha? You slipped in the term that he “consistently” had alpha. I guarantee you that’s not the case.
In our study I just referred to, 80 of the 614 managers had positive alphas. The average alpha was 0.84%. The average standard deviation of the alpha was 5.64%. With those two numbers, I calculated I would need 180 years of data before I could be 95% confident that the alpha they claimed was not actually zero.
One of the problems you have with managers like Soros is they close some funds. Not including the closed funds is called survivorship bias of the data. How horrible were those funds? What happens is managers basically close what turned out bad and leave open what turned out good.
Why isn’t there a possibility that the ones that turned out good weren’t due to just chance? The investment industry has had a horrible record in what I’ll call “a rigorous statistical analysis.””
What other reasons do you have for recommending index funds?
“A risk-appropriate return is really what an index fund or a benchmark captures. The real questions for investors are, “How can I position my portfolio to have the best chance of actually capturing that return for the risk I took?”
There are three key elements for doing that. Number one is the complete diversification of every investment that meets your criteria. So, if you want to invest in small caps, you want all small-cap stocks in the entire world.
You want the 10,000 stocks that meet your definition of small because that minimizes the random errors in the pricing of those stocks. Prices are only best estimates, not the perfect price.”
What’s the second element that will improve investors’ chances?
“And the way we minimize those random errors even further is by holding for a risk-appropriate period—the second key element. The longer you hold, the more you hold, and the more likely you’ll be appropriately paid for the risk you took.”
And the third element?
“Keep your costs and taxes at the absolute minimum. Portfolio turnover is part of those costs. I don’t want a manager trying to identify which stocks are mispriced.
When there are 5,000,000 willing buyers and 5,000,000 willing sellers each day in the world, how in the heck does a manager know more than those 10,000,000 traders?”
Could you explain in more detail how diversification will help investors capture risk-appropriate returns?
“The expected return of an index is the same as every stock in that index, but the index has greater certainty of achieving that expected return.
Now, active managers would challenge this, but we have no idea which stock will generate which return in the future. That’s evident by the lack of stock-picking skill of those managers in the study, right?
What this means is, diversification is your buddy and the only free lunch in investing because you can buy that index at the same or lower cost than buying a stock and have the same expected return.”
What attracted you to this subject in the first place?
“A friend of mine was killed in a car wreck and left his widow a substantial amount of money. She said to me after being bounced around by various investment managers, “You’re a good businessman; you must understand investing. Help me translate what my investment manager is telling me.”
At that point I’d been 12 years with Morgan Stanley and really never understood what they were doing either. So, I told her, “You know, I’ve always wanted to dig into this for my own portfolio, and you’ve given me the push I needed.
I bought John Bogle’s books and Burton Malkiel’s books, among 20 others. And you know, what I’ve been telling you has been well known since the early 70s.
Anyway, I decided there was a real need to have a real quality education for investors to get them to do this right, so I wrote this book.”
How to Invest in Index Funds: An Interview with Mark Hebner was written by Gregory Taggart.