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What the Heck is an Index Fund, and Why Would You Want One?

what is an index fund

Ryan Ong

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An exchange traded fund is a super risky investment. Imagine an airline that saves money by not hiring a pilot – that’s what it is. “That’s a complete lie.”  Also, exchange traded funds are a big threat to actively managed funds, so fund managers may or may not be above bribing me to say bad things. Take a guess:

What are Exchange Traded Funds?

Exchange traded funds (ETFs), or “tracker funds”, are a form of passive investment. Like mutual funds, ETFs work by pooling all the investors’ money to buy a mixed bag of stocks. The returns from an ETF mirror the returns from a particular index.

For example, say you have an ETF that tracks the Straits Times Index (STI). If the STI is up 7%, your returns are also around 7%. Simple.

You can create an ETF for any kind of index, from gold to coal to celebrities. In case you think I’m making that last one up, there’s an Angelina Jolie index.

Why Would I Buy ETFs?

There are plenty of reasons, but they come down to:

  • Lower expense ratio
  • Passive, low stress investment
  • Proven performance
  • Easy diversification
  • Less likely to blow up

 

1. Lower Expense Ratio

Most mutual funds are actively managed. They have a fund manager making decisions on which stocks in the fund to buy and sell, based on the reports of the financial analyst, or what the taxi driver said this morning. But I repeat myself.

Whether or not these managers make the right decisions, they still need to get paid. And when they perform exceptionally well, they of course deserve a bonus.

Guess where the money comes from.

Right. The Total Expense Ratio (TER) of a mutual fund is what you’re being charged. Besides fund managers, the TER also pays for office space, administrative staff, and posters of smiling old people that the finance industry imagines is good advertising.

The higher the TER (it’s often around 2%), the better a fund needs to perform to earn your returns. If your mutual fund generates 7% in returns, but the TER is 2%, you end up with 5%. If the fund does badly and returns are 2%… you see where this is going.

ETFs tend to have lower TERs than actively managed mutual funds – sometimes as low as 0.5%. Even if the overall performance of the ETF winds up comparable to a mutual fund, you still get higher returns because of the lower fees:

Mutual fund with 7% returns, minus 2% TER = 5% returns

ETF with 7% returns, minus 0.5% TER = 6.5% returns

 

2. Passive, Low Stress Investment

ETFs are passive investments. You buy them for the long term and slowly accumulate returns. Short term fluctuations in the market aren’t a worry, because the value of your ETFs will climb back up in time.

This makes ETFs the ultimate product for lay investors – you don’t need to check on your stocks every day, read charts, or worry about timing the market. And unlike stock traders, you will only drink alcohol for fun.

 

3. Proven Performance

Most mutual funds don’t outperform the market. Some might, but it’s estimated that about 50 – 80% of fund managers will fail to do so (and 100% will promise otherwise).

Now, since ETFs track the market and provide equivalent returns, it also means ETFs often outperform mutual funds.

In Singapore, the Straits Times Index fund has delivered annualised returns of as high as 9%. Compare that to many local mutual funds, which consider 7% to be optimistic.

 

4. Easy Diversification

You don’t want all your stocks to be closely interrelated. When 90% of your portfolio is related to, say, agriculture, a single tornado might wipe out years of accumulated wealth.

For safety’s sake, you need your stocks to be spread across a range of different sectors. This is expensive, and about as convenient as using a NTUC plastic bag as a contraceptive.

Say you want to buy a little bit of every stock: you’d need to research all the different companies you’re buying, most of which you won’t understand. You’d then need to work out whether you’ve diversified too much (resulting in poor returns), or too little (the risks are still too high).

If you just buy units in an ETF though, you automatically diversify among all the stocks in the fund.

 

5. Less Likely to Blow Up

Fund managers are inclined to take risks with your money. The two reasons being (1) higher risk = higher returns and a bigger bonus, and (2) I’m sorry, what part of “risks with your money” don’t you understand?

There is a small chance that the extra risk will result in a financial meltdown of epic proportions (see: Lehman Brothers).

With ETFs, this is less likely to happen. The fund simply tracks what the market is doing, and provides a proportionate return. It’s not trying to beat the market, so the only risks you face are threats to the market as a whole.

And if something can threaten the market as a whole, mutual funds are probably just as badly affected. So ETFs still trump in that regard.

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Ryan Ong

I was a freelance writer for over a decade, and covered topics from music to super-contagious foot diseases. I took this job because I believe financial news should be accessible and fun to read. Also, because the assignments don't involve shouting teenagers and debilitating plagues.

  • QC

    Hi Ryan,

    Index funds and ETFs and two different investment tools. You talk about Index funds in your title but the whole article talks about ETFs. Although they are similar in nature, readers should know the difference between the two to avoid misleadingness or confusion. Can you please clarify?