ETF Academy Ways to Invest: Index Funds
Index funds are synonymous with many ETFs. They seek to track the value of a market index – for instance the FTSE 100 Index that benchmarks the value of UK equities – rather than beating the index.
Index investing: The new trend
Index investing, also called passive investing, has increased rapidly in popularity and is the main method of investing practised by ETFs. While active investors in traditional mutual funds seek to perform better than an index, with mixed success, passive investors recognise the limitations of human investors and just seek to track the value of an index.
What is an index fund?
An index fund is a fund based on index investing. A professional portfolio manager constructs a fund designed to follow an index on your behalf.
Tracker fund is another name for an index fund.
What are the advantages of index funds?
Index funds charge significantly lower fees to investors than active funds. The reason is simple: the asset manager does not need to pay for fund managers, analysts and external research. Nor do they conduct as many transactions. Over time, management costs have been shown to eat into your return in a big way. The following simulation shows how different cost levels affect an initial investment of 10,000 over 30 years. Just paying 0.25% annual costs, rather than 2%, can result in almost twice as much capital – assuming returns are the same.
The impact of fees
Many active managers justify their high fees by proclaiming the possibility of investment outperformance. Yet, objective research doesn’t bear this out. Markets are simply too efficient today for talented professional investors to consistently find mispriced investments. For instance, the data below shows that, over 5 years, 75.27% of active U.S. large capitalisation equity funds and 75.17% of active European capitalisation equity funds failed to perform even in line with their benchmark indices.
Percentage of European and U.S. domiciled equity funds outperformed by benchmarks
Source: SPIVA Scorecard; 31/12/2020.
Index funds: Why doesn’t everybody use them?
The answer is that index funds are relatively new and more people use them every year. ETFs, vehicles which specifically aim to replicate an index, have been steadily gaining market share in Europe. Currently, about 10% of assets are invested in them. In this respect, Europe lags behind the U.S., where index funds already account for the double. In both regions, the trend is upwards.
Market share of ETFs for Europe and U.S.
Source: Morningstar Asset Flows. Effective date: 1/1/2008 - 31/12/2020.
Historically, many financial advisors recommended active funds as they were more profitable for them. Either the higher fees were pocketed by the financial institution for which they worked, or commissions were paid. New regulations, such as the EU's Directive on Markets in Financial Instruments (MiFID II), are designed to make advisors put their clients’ interests first. The result? Index fund sales increased as the fee structure of many financial products became more transparent.