What Is An Index Fund? | Brandon Averill, Justin Dyer | AWM Insights #104
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Episode Summary
You have probably heard of the S&P 500, Dow Jones, or Nasdaq. These indexes are created to track the performance of a group of public companies. While you can’t invest in an index itself, you can invest in strategies that mirror the performance of an index.
Warren Buffett, the greatest active investor of all time, is a fan of index funds. Warren understands how difficult it is to beat the market and has directed his estate to buy index funds when he is gone.
There are also weaknesses with index funds – specifically with their strict mandate of tracking the index. In this week’s episode, Brandon and Justin discuss the strengths and weaknesses of index funds and the many small areas of improvement and efficiency that provide opportunities for long-term investors.
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Episode Highlights
(1:10) What do we mean by indexing or “passive” investing?
(1:55) An index is a rules-based classification that organizes companies (stocks) into a common basket and measures them daily.
(2:35) The Nasdaq, the Dow Jones, and the S&P 500 are the most commonly quoted by the media.
(3:02) The S&P 500 index is the 500 largest companies in the United States.
(5:00) It isn’t possible to buy an index directly. It is only data and a representation of a basket of stocks.
(5:57) You should select several indexes when building your portfolio to ensure global diversification.
(6:20) You can buy an “index fund” in an ETF or mutual fund wrapper. Not all ETFs are passive index funds.
(7:18) A significant advantage of index funds over active stock-picking is the lower expenses. These higher expenses and transaction costs decrease your returns.
(7:55) Many active funds generate large tax bills that do not make sense for those with large amounts of assets in taxable accounts.
(8:50) Warren Buffett has stated many times that his investments will go into passive index funds when he dies. He is the best active investor of all time, and he advocates buying index funds.
(9:30) What are some of the downsides or negatives of only passive vehicles?
(10:02) Indexes must be reconstituted periodically, allowing other investors to front-run this known event.
(11:10) Tesla’s recent addition to the S&P 500 index is an example of an area of improvement.
(12:10) Adding just 20 basis points of long-term compounding annually contributes substantially to the growth of wealth.
(13:08) Can Indexes be improved if you systematically exclude underperforming companies to increase returns?
(14:20) Flexibility and leverage when buying a car provide you with a better opportunity to get the best price. This holds true in the stock market.
(15:15) As an investor, you want to have a philosophy that you can believe in and stick with. If you can't do that, you are set up for failure.
(15:55) Takeaways: Check your portfolio for global diversification; just an S&P 500 index fund isn't good enough.
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+ Read the Transcript
Brandon Averill (00:00): Well, Justin, we're back, and we're going to move on to a topic that I think most people are somewhat familiar about. And coming off of last week's episode, or a couple weeks ago, when we talked about the ridiculousness of active investing, we actually move into a space that hopefully is a little bit more applicable for everybody, and a place that we could start to form and shape our investment philosophy, start to form and shape our investment portfolios. And let's just say this is probably a great approach for the 90% of people out there, teasing it out a little bit.
Brandon Averill (00:37): We'll finish up with a little bit of a look into where we'll go in the next few weeks, just a better way to actually go about investing. But for this week, I think we're going to continue to build on, "Hey, we've hammered the active debate. It is certainly not the best." At least if you want to pay attention to evidence and you want to take a look at the statistics, you're certainly not going to be an active investor, predicting the next coming and the crystal balls and everything.
Brandon Averill (01:06): So where do we go from there? And it leads us to this topic of indexing or passive investing, Justin. And I just thought it would be really good if we start out again today with some definitions, some just broad-based. What are we thinking about? What are we even talking about when we're talking about indexing or passive investing?
Brandon Averill (01:26): So I'm going to turn it over to you. What do you got for us when you're thinking about indexing or passive investing?
Justin Dyer (01:33): Sure. So obviously, this topic has become very, very, very big within the investment world, and I think that's also bled over into just broader society and media outlets and whatnot, as it rightly so has become a bigger and bigger portion of investible assets.
Justin Dyer (01:53): So what is it? It's a broad category, and not all indexes are created equal, so let's first put that right out there. But the simplest definition is an index is a rules-based classification that organizes companies or stocks, could be bonds, as well, into a basket. And it measures them on a daily basis. It's really that simple. I think in the past episodes, we mentioned a lot of the more common indexes out there. So if you're listening to the news or watching the news, you'll hear, "How did the NASDAQ do today? How did the Dow Jones do today? How did the S&P 500 do today?" Those are indexes. These are the common indexes cited to give a pulse on what's going on within the markets.
Justin Dyer (02:44): The S&P 500 is a perfect place to just really tie this definition back to what I was saying. The S&P 500 is essentially the 500 largest companies in the United States. Doesn't matter if they're traded on the NASDAQ Stock Exchange. It doesn't matter if they're traded on the New York Stock Exchange. They are the 500 largest companies in the United States. There's some nuance to that. It's not like, "Hey, automatically, if the 499th company goes to 501, it's going to automatically be removed." There's a methodical process to how they add and remove companies, Tesla being the biggest one that was more recently added. And Tesla needed to get to a certain amount of profitability. They made a decision to bring them into the index. Won't go into too much of that today.
Justin Dyer (03:31): But essentially, really rules-based. That index is trying to represent the 500 largest companies in the country, in the United States. But again, I said not all indexes are created equal. When we're talking about the benefits of index investing, we're talking about these broadly-diversified type approaches. We're not talking about some esoteric index that potentially follows the weather on any given day. I'm using some hyperbole there or getting a little creative, but you can find an index to represent almost anything in the marketplace that can come up. And at a certain point, you start to lose the benefits of rules-based, broadly-diversified, et cetera, cetera.
Justin Dyer (04:20): So when we're talking about this in a positive context, want to really underscore the fact that we're talking about these broadly-diversified indexes: the S&P 500, the Russell 3000, which, similar to the S&P, looks at the 3000 largest companies out there. So keep that in mind. With this day and age, and because there's been this proliferation of interest, again, rightly so, in index, more passive investing, a lot of new products have come out to meet that demand. And those products aren't necessarily the best.
Justin Dyer (04:55): The one thing I would add, and then I'll turn it over to you, as well. You can never buy an index directly. If you ever read the fine print on some statement or whatnot, you'll see those exact words. But it's true. An index is just pulling the data from the market on any given day and aggregating it and giving you the results. You can't go buy that index. You can buy a strategy that tries to replicate that index, and some of them are very, very good at replicating it, but you can never buy an index directly. I think it's really, really important to underscore that.
Brandon Averill (05:30): Yeah, I think I'm glad you went there, because that's what I was going to mention, Justin. Again, that index, and you brought up the S&P 500. Yeah, I'll say it. It would be pretty ridiculous to only hold the S&P 500 in your investment portfolio. So what we're talking about are when you start to form and shape a successful portfolio for yourself, what you actually probably need to do, or one of the things you could do, is you're going to select several indexes to build out a globally-diversified portfolio.
Brandon Averill (06:01): And then there's the vehicles. Like you said, Justin, you can't go invest directly in the index. So where can you go? Well, I think most of us think about indexing and ETFs as this synonymous thing, and we've hit on this in the past couple weeks. But you can actually purchase a vehicle that tracks the index in a mutual fund. You could purchase it in an ETF. So all those definitions have largely been broken down, but when we talk about the passive side of this, what we're talking about is using one of those vehicles to basically mimic or come as close to that index that you just talked about as possible, Justin.
Brandon Averill (06:39): So I think what we're not saying here is, "Run out and just go buy an index," because that's not going to solve your problems. What you really need to do is look for vehicles that do mimic indices, but you want to make sure that you're still getting that broad global diversification that you deserve and that we know leads to a better investment experience and portfolio over time.
Brandon Averill (07:05): And just to go back, because we can't talk about passive in indexing without bringing back up the active, but at the end of the day, it is so much more successful than active investing, for a few reasons. We had talked about this in past weeks. But that active trading of those ETFs or mutual funds or individual stock portfolios that maybe you got some broker at one of these wire houses, still. And you're listening to this podcast. I don't know how that is still happening, but you do.
Brandon Averill (07:37): You end up eating up most of your return, because of transaction costs. Typically, you have to pay that person to use their crystal ball more than you would somebody else, so the expenses are higher. And then they generate a heck of a lot more taxes, because if they're turning over the portfolio in a taxable account, you're paying taxes on those every year. And kind of interesting time for this podcast, because we're seeing this time and time again, where these 1099s are coming in. People think they did fantastic over the last year, but then you start to say, "Well, shoot, do you realize that now you got to pay? You traded those on a short-term basis, and now you got to pay ordinary taxes."
Brandon Averill (08:21): So again, I bring it all up, because this is a really, really good approach to building an investment portfolio, to own these vehicles that mimic broadly-diversified indexes as they start to round things out. But one thing I certainly would be remiss if we don't start to hit on, Justin, is having these vehicles that are more passively tracking indices is a really good way of investing. In fact, Warren Buffet, what we credit as the most successful ... Most people credit the most successful active investor of all time, certainly of our lifetime. In his will, actually, when he passes away, he has very clear instructions that his money then goes into these passively-diversified indices with a very famous company. So if the most active investor out there thinks this is a really good way, it probably is a really good way.
Brandon Averill (09:21): But there's also some trade-offs. There's some downsides to these passive indices and just accepting what it is and the ability of these vehicles to try to track indices. So Justin, maybe hit on for us a little bit, like, "Okay, that's great. You painted a really good picture. It's a good way to do it, but we're kind of teasing out. There's probably a better way, and what are some of the negatives to going this route?"
Justin Dyer (09:46): Yeah, going back to the Tesla example that I mentioned as being brought into the S&P 500 more recently. I want to start there. That whole episode, if you will, is what's called reconstitution. So these indexes, again, very rules-based, depending on what index you're talking about. At some point in the year, maybe it's mid-year, maybe it's at the end of the year. It really depends. They then use that date and time to say, "Okay, we're going to pull this company out of the index, and we're going to bring this company into the index." That happens on a specific date and time. It's telegraphed out to the market. Everyone knows it's going to happen, and guess what? People can take advantage of that.
Justin Dyer (10:33): And there are really, really robust studies and really interesting data out there, to say, "Well, hey, we like tracking a rules-based index, but we don't like just blindly following what they're doing when they're telegraphing to the market beforehand what exactly it is they're going to do."
Justin Dyer (10:53): So let's say we want to have that more passively-oriented approach, but we want to have some flexibility around adding new companies to the portfolio or not. That is an area of improvement. The Tesla example. If you look at that, the market bids that stock way up, right before it's added to the index, because they know, all of a sudden, the next day, these people who are just blindly following the index, are going to have to buy it from them. They're like, "Sweet. This is great. I get to literally front-run," which is a four-letter-word in our world. But doing it when it comes to indexing is completely legit.
Justin Dyer (11:37): So that's one example, like, "Hey, let's look at the benefits, but also, let's see if we can break down some of the construction of it and be a little bit smarter, to add some value at the end of the day." And we're talking about basis points right here. But if you can add basis points versus the index, you can do it in one area over here, another area over there. It really starts to add up and add some meaningful value. Let's just say you were able to save, I don't know, 20 basis points, relative to the index, doing some various things. Margin lending or securities lending is another thing we can touch on briefly, but don't want to go too much into the weeds, if possible.
Justin Dyer (12:20): You think about that compounding difference over time. Again, we're very much long-term investors. It's substantial. I mean, you compound wealth at a difference of 20 basis points or 0.2%, which is what 20 basis points is. It's substantial. It really, really, really is a meaningful difference there. So there are these aspects to indexing, because they're so rules-based. And because they're not investment products, in and of themselves, you can be a little bit smarter, relative to the index.
Justin Dyer (12:57): One other thing I would add, too, is a lot of these indexes, we've said, are broadly-diversified, looking at the entire market. Well, maybe it makes sense to look at that entire market and be diversified, because that is truly a free lunch. But let's say, "Hey, let's look at what small companies are doing, relative to large companies." Typically, smaller companies tend to outperform, over longer periods of time. Can we favor those companies in the portfolio, as well?
Justin Dyer (13:27): So things like that, where you look at the underlying data, the construction of the index, and try and produce something that takes advantage of the weaknesses.
Brandon Averill (13:38): Yeah, I think that's fantastic, and a great start to start to explain why there is a better way. I think the good example I'll quickly hit on, of reconstitution, always made a lot of sense to me, and I think would resonate with a lot of people listening. It's like going to the car lot, and you want to buy a red Tesla Model S today, and you have no flexibility. And maybe Tesla's wrong, because they set their prices.
Justin Dyer (14:05): You can't negotiate that.
Brandon Averill (14:05): You want to go buy a red Ferrari. Yeah, you want to go buy a red Ferrari today. You're going to show up on the lot, and you have no flexibility. You can't come tomorrow. You can't come the day after. You want red. You won't go for blue. You won't go for silver. You won't go for black. When you walk in, how much leverage do you have to actually get the best price? Not very much. If you're willing to wait three months, you're willing to show up to the lot a few times, change up the color, et cetera, now you start to open up the possibilities. And it allows you to get a better price, most typically.
Brandon Averill (14:35): So I think that's a great way to start to look at it, and we're going to unfold so many of these topics over the next few weeks, and we're going to lead you down this path of what is a better experience? What is a better investment experience? And hopefully, you've got an advisor that guides you through that type of process.
Justin Dyer (14:53): One thing I want to hit on before we wrap, too, and I think we'll consistently hit on this throughout, but we're building this foundation up to our philosophy, specifically, but a philosophy in general. And it's so important to understand, as an investor. You want to have that philosophy that you can believe in and stick with, because if you can't do that, you are set up for failure, really, at the end of the day. And you want to do this within your priorities, your time horizon, in a way that's custom to you. And it's just such an important aspect to really keep in mind, to ground this whole little journey that we're going on here. That philosophy that you can stick with matters so much to your long-term investing success.
Brandon Averill (15:48): Yeah, no, I totally agree, Justin. So our key takeaways for today. You want to own broadly-diversified indices, and what flavor those takes is a little bit up in the air, to an extent. But you want to make sure you have global allocation. So your action item for this week is to go look at your portfolio. Take a look at what you own. If you only own an S&P index ... If you own some active stuff, certainly figure that out. But if you own an S&P index and you don't own any international, start to ask the questions of: Why? Ask your advisor, "Hey, why are we allocated this way?" I think that would be a great action item for this week. And then as we come into the future weeks here, we'll give you some more action items as you take a look at your portfolio, because in our view, there is a slightly better way to go about things.
Brandon Averill (16:39): But before we close out here, I just want to remind everybody: You can text me directly. It's great to get this feedback from people. We got some great feedback from Brian last week. Shot a message over and said, "Hey, I love the length of these now. They're a little bit shorter. I can actually listen to them on my ride in to the office." That's really helpful for us, and so we try to watch the clock and make sure this is digestible and concise for you guys. And we love that type of feedback. We love to hear about topics you guys want to hear about.
Brandon Averill (17:10): We're going to probably take a deviation next week and talk a little bit about a quarterly-type update, and then we'll get back on this investment experience track. But if there's something really passionate to you, we want to hear about it. So the way to do that: Shoot me a text. You can shoot me that text at (602) 704-5574. Again, it's (602) 704-5574. Just throw that word Insights in there, the little light bulb emoji. Shoot me your feedback, your question, and we'll certainly address it. But we appreciate your time. And until next time, own your wealth, make an impact, and always be a pro.