Recently I spent a very enjoyable Saturday at the London Investor Show, a seminar/panel-driven event run by Investor Conferences UK, aimed squarely at retail investors. It was a rare opportunity to talk to and listen to our ultimate clients, rather than to the ETF issuers (and other index geeks!) that are my daily bread and butter.
I spoke on the subject of “Indexing, past, present, and future,” focusing on the wide range of investment opportunities that indexes are supporting through index funds and ETFs and on the possible future of direct indexing. The session was well-attended; I had to be dragged off the stage amidst many incisive questions, and the questioning continued afterward well into lunch.
My key takeaway was this: We, in the industry, think that index-based investing and the opportunities it gives are understood well. It isn’t, at least by retail investors, and if a self-selecting audience of relative experts—at least amongst the retail-investor space—was so interested to discover the opportunities it offers, then probably a significant majority of retail investors would benefit from being told, or reminded, of these benefits. So, I offer this quick rundown of the benefits of indexing in the hope that it can be used to get the message out to retail investors.
Index-Based Investing: A Smart Strategy for Retail Investors
The use of index-based investments such as index funds and ETFs, as opposed to the use of active management of investments right down to individual stock level, is common amongst professional investors, but it has been relatively slow to be used by retail investors. However, it is steadily gaining popularity due to its simplicity and effectiveness. It’s a method that allows retail investors to participate in the stock market without the need for extensive knowledge, significant time investment, or hefty fees, while also offering significant advantages for those who are more actively involved in their investments. This article explores the benefits of index-based investing.
What Is an Index-Based Investment, Anyway?
An index is a number whose movement tracks the collective performance of a group of assets or segment of a market, whether equities, fixed income, commodities, or anything else. If the number is up 2%, the value of the group of assets has, on average, risen 2%. Common examples include the S&P 500, which tracks the performance of 500 large companies listed on US stock exchanges, and the FTSE 100, which tracks 100 of the largest companies listed on the London Stock Exchange. An index is therefore a “paper portfolio”: investors cannot invest in an index directly.
Index-based investing, effectively synonymous with passive investing, is the strategy of building a portfolio that aims to replicate the performance of a specific index or indexes. This can be done by individual investors, but it is most easily done through those investors purchasing index funds or exchange-traded funds that have themselves been designed to mirror the asset allocation and therefore performance of a chosen index. ETFs are a type of index fund that is traded on stock exchanges, much like individual stocks. They offer all the benefits of traditional index funds, including broad diversification, low costs, and tax efficiency. But they also provide the flexibility to be bought and sold throughout the trading day at fluctuating prices, unlike traditional index funds that are only priced at the end of the trading day.
Achieving Higher Returns
One of the most compelling reasons to consider index-based investing is the potential for higher returns over time. Active fund managers strive to beat the market by buying and selling stocks based on their predictions—but (to put it mildly) this is difficult. Index funds avoid the costs and risks associated with stock-picking and market-timing, and they simply aim to mirror the performance of a specific market index. Research (such as our Morningstar Active vs Passive Barometer) has shown that over the long term, index funds tend to outperform most actively managed funds within a similar investment category, such as the broad market or large-cap stocks.
Saving on Fees and Taxes
Besides the potential performance gains, index funds are also more cost-effective than their actively managed counterparts. They have lower management fees and expense ratios, as they do not require a portfolio manager, nor frequent trading. This means that a larger portion of the invested money goes toward growing your wealth, rather than paying for administrative costs.
Also, index funds on average generate fewer capital gains distributions, which can translate to a lower tax liability. This is because they employ a buy-and-hold strategy, which involves less buying and selling of securities compared with actively managed funds, and because they often reinvest the dividends they receive. As a result, they incur fewer taxable events, helping you keep more of your earnings.
Easy Diversification
Diversification is a key principle in investing, because more companies fail than succeed over the long term. Diversification simply involves spreading your investments across various assets to reduce exposure to that risk. Index funds make diversification easy by comprising all the constituents of an index. Further diversification—like buying a range of index funds and thereby gaining a diversified exposure to a broad range of assets, sectors, and markets—is also easier.
For instance, an index fund tracking the S&P 500 gives you a stake in 500 of the largest US companies. This means that even if some of its constituent companies perform poorly, your overall investment is likely to remain stable because it’s spread across many different companies. With a handful of additional index funds—for example, a global ex-US large-cap fund, a global small-cap fund, and a fixed-income fund—you have diversified exposure to global equity and bond markets.
Tailored Investing
Index funds allow you to tailor your portfolio to your specific goals and preferences. Whether you’re a risk-taker or a cautious investor, a portfolio of index funds or ETFs can be built that very closely gives you the investment exposures you want. There’s almost always an index fund that matches your desired exposure, or even matches your desired level of volatility and growth potential.
Furthermore, if you’re an investor who values social responsibility or is focused on climate, there are index funds that focus on companies with strong environmental, social, and governance practices, or that are reducing their contribution to climate change. This means you can invest in a way that aligns with your values.
Simplicity and Convenience
One of the greatest advantages of index-based investing is its simplicity and convenience. Index funds are straightforward, easy to understand, and easy to access. You can invest in them through various platforms, such as online brokers, robo-advisors, or financial advisers. ETFs are even easier, as they are bought and sold just as shares are on major exchanges.
Implementing Active Decisions Through Less Expensive Index-Based Investments
Finally, all the above benefits are available to investors who still wish to use their expertise to actively manage their portfolio. It’s easy for investors to implement active decisions, and in particular their desired asset allocations, by varying exposure to the many index funds and ETFs that are available. And these funds also allow investors to make quick tactical adjustments to their portfolios in response to market conditions while still enjoying the benefits of index investing.
To Conclude
Index-based investing offers a host of benefits for retail investors. It’s a strategy that combines market returns, cost-effectiveness, diversification, customization, and convenience. Whether you’re a seasoned investor or just starting your investment journey, index-based investing could be a smart strategy to consider.
So, there you have it! Index-based investing is a strategy that combines potential high returns, cost-effectiveness, diversification, customization, and convenience.
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