BY ANTONY MUTUNGA
“Don’t look for the needle in the haystack. Just buy the haystack!” – John C. Bugle, founder of Vanguard Group
Over the years, a lot has changed in the way people thought about investing. Investors in the past mostly depended on professional stock pickers to select stocks that were worthy to invest in. However, things have changed as people have been given the option of investing in all of the stock in the market. This was all possible thanks to John Clifton ‘Jack’ Bogle.
In 1975, inspired by the works of Paul Samuelson in 1974, Charles Ellis and Al Ehrbar in 1975 on indexing, Bogle introduced what was arguably the most important change in an investor’s options in a generation by creating the first index fund. The index fund being a collection of securities that tries to copy the performance of a well-known index, which is a select assortment of stocks and bonds that follow a certain market. Using his company, the Vanguard Group, which he founded in 1974, he named the first index fund the First Index Investment Trust, a precursor of the Vanguard Index Trust, and made it available to the general public.
The index funds started off on a rough patch since many investors did not understand the notion, as they were mostly keen on beating the market rather than meeting it. This saw index funds become popular at a slow rate but it was worth the wait. After three decades, index funds started to pick up pace and eventually it was able to hit the trillion-dollar mark. Since then, index funds have only gotten more and more popular all over the world.
Examples of index funds include the likes of the iShares MSCI Emerging Market Index (EEM), the Dow Jones Industrial Average and PowerShares QQQ (QQQ), which tracks the Nasdaq-100 index.
Index funds have revolutionized the investing world, not only helping people save but also leading to the development of other new investment options. Index funds, which are passively managed, have enabled investors to shift from active managed funds, causing money to flow out of active to passive managed funds. For example, according to Bloomberg news report, nearly $500 billion was moved from active to passive managed funds in the U.S only for the first half of 2017.
The growing popularity of the index funds can be mostly accredited to the fact that the fund is extremely diversified. This assures the investor that there is minimum risk, as they do not have to worry about the concentration of risk since one doesn’t have all his/her eggs in one basket.
Index funds also have low costs when compared to some other funds like active managed funds. One of the reasons as to why Bogle created an index fund was because he felt that the financial sector was being unfair by taking advantage of investors. Bogle demonstrated that investors were incurring hidden costs when dealing with active managed funds.
This is demonstrated today whereby active managed funds usually come with high management fees compared to passive managed funds like the index fund. This is because they require fund managers, analysts, traders and a whole host of other experts to give one a perceived value. This burden is usually passed along to the investor as compared to index funds that focus on the average and thus they do not need to spend much money. Vanguard’s equity index funds, for example, averages a 0.20% expense ratio as opposed to 1.12% for actively managed funds.
The fact that index funds guarantee average returns is another reason they have become popular. The aim of active managed funds is usually to beat the market by making above average returns, but this is not usually the case for index funds as they work towards the average at the least. This ensures an investor that at the end of the day will at least be able to achieve the average as compared to active managed funds that tend to fail most of the times, leaving investors with even less than average.
Apart from this, index funds require less maintenance, giving investors the option to just save and forget. There being no active management, all that is needed is for an investor to invest and wait so that in a couple of years they have a lot saved. It enables the investor to save both time and money. Index funds are also perfect because they are tax efficient. This is because unlike active managed funds, which usually shift positions and increase their possibility of capital gains, attracting higher tax rates, index funds have a low turnover ensuring they have less tax gains.
This has seen index funds get support from several financial gurus, among them the Chief Executive Officer of Berkshire Hathaway, Warren Buffet who believes that a huge percentage of investors should extensively aim to diversify and not trade. Henceforth, this should lead them to index funds, which have very low costs.
However, index funds are not without their own critics who believe that they are not completely good investments. This is because as much as it is said that index funds require less maintenance, investors will need to be attentive towards asset allocation. This refers to the mix of stocks and bonds in the fund. It is important to ensure that the asset allocation you choose reflects to your risk tolerance, financial situation, and time horizon.
Another major risk of index funds is the fact they leave the investor exposed to full market risk. As a result of the fund being fully invested in an index all the time, it exposes investors to full market volatility. In the case the market is volatile, the investor then will incur losses.
Regardless of these shortcomings, index funds give investors a choice to be able to diversify their investment portfolio. With high costs being a major problem in the investment sector, investors now have the opportunity to choose index funds, which are better off and give one peace of mind that they do not have to keep worrying about beating the market every year in order to earn returns.
