Investing used to be a taboo word for me.
I’ve heard many stories of people losing their money in the stock market. This made me think of investing as gambling.
After becoming interested in making my money work harder for me, the topic of investing popped up again. After reading up more, I realised that you could actually earn from the stock market in a stable way!
One such way was via the passive investing route, where you invest in index funds. Here’s why I think index funds are a great way for anyone to start their investing journey.
- What is an index fund?
- What is a market index?
- Can you lose money with index funds?
- Are all ETFs considered index funds?
- The costs of index investing
- Why is index investing better than stock picking?
- How can I start index investing?
What is an index fund?
Index funds were first introduced in 1975 by Jack Bogle. He wanted to create a low cost fund that mimics the performance of a market index.
These are in contrast to mutual funds (or unit trusts). Mutual funds are usually run by an asset management company. They would pool money from investors to invest in different investment vehicles.
The fund manager generally has the aim of beating the market, and will select stocks that they think will outperform the market.
Due to the high volume of trading, mutual funds usually charge high fees. Moreover, a mutual fund does not necessarily outperform an index fund! The S&P 500 is a US index, and has consistently outperformed active fund managers.
So rather than trying to beat the market, why not just follow the market? Time and time again, the markets have proven to go up.
Looking at the performance of S&P 500, you will see some ups and downs. But overall, you can see that the trend is always up.
Jack Bogle thus created a method of staying invested in the market, without having to actively pick stocks. The stocks in the index fund are automatically chosen to match the index. This usually means fewer transaction fees incurred by the fund.
As such, index funds usually have a lower cost compared to mutual funds.
What is a market index?
A market index tracks the performance of a certain market. There are many examples of indexes. They include:
- The Straits Times Index (STI), tracking the Singapore market
- The popular S&P 500, tracking the top 500 companies in the US
- The MSCI World Index (possibly the most diversified), which tracks the top companies across 23 developed markets
These indexes usually give a weightage to each company. This will determine how much that company affects the whole market. The two most commonly used weightages are:
- Market capitalisation
Market capitalisation takes into account all units of the stock held by shareholders (i.e. outstanding shares), and multiplies it by the stock price.
Hence, the companies on the index are weighted based on their market capitalisation against the capitalisation of the entire market.
The STI and the S&P 500 are examples of market-cap weighted indexes.
|Share Price||Outstanding Shares||Market Cap||Weightage|
Price weightage just takes into account the price of each stock in the market and the proportion is adjusted accordingly.
The Dow Jones Industrial Average is an example of a price-weighted index.
When you buy into an index fund, you’re essentially buying into all the stocks in the index. It is much more diversified compared to buying an individual stock!
Can you lose money with index funds?
It is possible to lose money with index funds. By tracking the index, the fund’s performance is heavily linked to the underlying stocks’ performances.
When the market crashed in March 2020, all the index funds dropped in price as well.
Performance of the Nikko AM STI ETF that plunged during the March 2020 market crash
If you had bought into the STI ETF in early February 2020 (like me), you would have seen a significant drop in your investment.
However, since you’re buying into a basket of stocks, the risk is slightly mitigated. Some stocks may drop less in price compared to others, so the drop in the index fund’s price may be averaged out.
Then again, it depends on the weightage each stock has in the index. Although index funds are slightly more diversified, you shouldn’t treat them as risk-free investments!
Are all ETFs considered index funds?
A word of caution here, in case you assume that all ETFs track an index fund. I used to have this misconception as well!
The definition of an ETF just means that they are funds that can be traded in the stock market. It is possible that an ETF can be actively managed, instead of following an index.
One such example is the ARK Innovation ETF (ARKK).
From its website, it is an actively managed ETF that selects stocks that are “relevant to the Fund’s investment theme of disruptive innovation”.
It is very important to look at each ETF’s underlying strategy to ensure it is tracking an index!
The costs of index investing
An index fund aims to replicate the performance of the index. You will only be able to get the returns of the market, and will never be able to ‘beat’ it.
You may get an even lower return due to:
- Tracking errors
- Expense ratio
At regular intervals, there may be a rebalancing of the index.
Rebalancing means that the weightage of each stock in the index will change.
It’s even possible that a stock is no longer part of the index and is replaced by another stock. In June, MapleTree Industrial Trust replaced SPH as one of the 30 companies in the STI.
There will be a lag between the rebalancing of the index, and that of the index fund.
The index fund, such as the Nikko AM STI ETF, or the SPDR STI ETF, would need to buy and sell the different stocks to fit the allocation specified by the index. This lag results in the tracking error, which may affect your returns.
Another thing you need to consider is the expense ratio. This is an annual fee that the fund manager charges the shareholders.
Here are some expense ratios of the more popular index funds:
|Vanguard S&P 500 ETF||0.03%|
|Nikko AM STI ETF||0.3%|
|SPDR STI ETF||0.3%|
|ARK Innovation ETF||0.75%|
The average expense ratio for an ETF is around 0.44%, so you should strive to keep your costs below this average. Usually, the projected returns that each fund advertises will be the gross projected yield.
You’ll need to deduct both the expense ratio and the tracking error to determine your actual returns.
Why is index investing better than stock picking?
In a recent webinar by Endowus, Dawn (the author of sgbudgetbabe) shared her stock picking experiences.
She pointed out 2 key elements needed for stock picking:
- You need a lot of time to learn stock picking
- You need to control your emotions and know when to say no
1. You need a lot of time to learn stock picking
By investing in an index fund, you’re leaving the stock picking to the index. This saves you a lot of time as stock picking can be extremely time consuming.
If you’re picking stocks, you would need to study the stocks’ fundamentals and understand it well before diving into it.
Are you willing to set aside time to learn investing and screen stocks?
2. You need to control your emotions and know when to say no
Even after doing all the research, you may have to say no to a stock if it doesn’t meet a certain criteria you have.
You may have certain thresholds on when to buy and sell a stock. But would you execute your plan when the stock price really reaches the threshold?
During the recent market crash, the price of many stocks plunged. Once the price reaches the threshold, would you still buy the stock, or would you have the fear that the price will drop further?
There are many people who still actively pick stocks. However, I have chosen the index route to give myself more time to do other things that I enjoy.
How can I start index investing?
If you’re convinced that index investing is right for you, here are some ways you can start getting invested!
Regular Savings Plans (RSPs) require you to make a monthly contribution each month. This can start as low as $100 per month.
It’s a great way to start investing, even if you have a very small starting capital! There are plans being offered by banks and brokers, including:
There are many ETFs to choose from each RSP. The ETFs offered by OCBC, DBS and POEMS are mainly those listed in the Singapore Exchange (SGX).
FSMOne offers more variety by allowing you to purchase ETFs in the Hong Kong and US markets as well.
Once you have a larger capital, it may be more cost effective to DIY invest via a broker instead. As a reminder, here are some things to look out for before you start investing!
- The ETF’s underlying index
- The ETF’s tracking error and expense ratio
Index investing takes away the time and emotional factors from investing. This allows you to be invested in the market without having the investing know-how.
Granted, you may not receive extraordinary returns, such as the 67% gross return on Apple’s stock price for the past 5 years (accurate as of 18 July 2020).
But are you willing to do so at the cost of your time, emotions and possibly even your sanity?
Ultimately, there is no right or wrong answer. It’s important to find out what you’re comfortable with, and execute out that plan!
Gideon, the author of “Financially Independent Pharmacist”, is a Pharmacy undergrad who aims to make personal finance accessible for everyone.