The growth and popularity of index investing has provided investors with a great opportunity to move their money away from higher cost mutual funds. However, low costs aren’t the only thing you need to consider these days.
When you drop the fund manager, you become the full-time decision maker for your investments. Done wrong, it opens the door to bad habits, confusion, comprehension risk, and losses. That’s never a good trade-off when discussing the benefits of index based funds, but it’s true.
For each index fund you own, you need to know the underlying index, what it measures, the asset makeup, how the index is weighted, the risks, and finally the costs. It’s a lot to cover, but it all impacts your performance. What once was a simple comparison tool has evolved into a complex investing strategy.
Stock Market Index
A stock market index measures the performance of a group of stocks built to represent the market or a section of the market. There are indices built to measure sectors, industries, market cap, the economy, the list is endless and growing.
There is one important note to all this, even though index funds and ETFs are based off an index, the SEC does not regulate how the index is built.
Index Turned Benchmark
It all started when investors compared their stock’s performance to the very first index. If you could beat the Dow you had a good year.
As the popularity of mutual funds grew, it was only natural to do the same. Eventually, investors turned to the S&P 500 as the index to beat for fund managers. Living up to those expectations become a fund manager’s yearly battle. In turn, a benchmark was born.
When you’re comparing your own investment performance it’s best to use a like-minded index. You certainly wouldn’t compare all your investment performance, stock and bond funds to the S&P 500. Apples to apples is more accurate than apples to oranges don’t you think?
Index Turned Investing Strategy
This benchmark status led to index funds. This is important. It quickly became clear that most fund managers couldn’t beat the S&P 500 in a given a year.
Instead of trying to beat the benchmark, the logical step was to create funds based on the benchmark, like that S&P 500 index fund in your retirement account. It’s the old – why beat em when you can join em…and still make money. Which is exactly what the fund families did.
Low Cost War
To build a S&P 500 index fund, a fund family pays Standard & Poor’s a licensing fee. This fee is cheaper than paying a fund manager, analysts, and staff to come up with stock picks that may or may not beat the index each year. A funny thing happened in return. It lowered the cost to investors. That result is why index funds and ETFs have become so popular.
The benefits of low-cost funds turned into an ongoing price war. It was a great deal for investors, but with the fund manager and staff gone, fund companies were left with lowering the licensing fee or changing the benchmark to lower costs. Vanguard was the first big fund family to make news with these benchmark changes.
Growth In Indexes
The popularity of index investing drove demand for new and unique ways to invest through ETFs. Specialized and exotic ETFs opened doors to new areas of the market most investors never had access to before.
The investor demand for low costs spurred growth in the number of indexes available. What started with Dow Jones and later Standard & Poor’s, has grown in recent years.
MSCI has over 700 indexes tracking different, unique areas of the market. Since that’s not enough, you still have Dow Jones, Standard & Poor’s, Nasdaq, FTSE, Russell, Wilshire, and CRSP indexes doing the same. In fact, S&P uses over 800,000 indices to measure different portions of the world’s markets with only a fraction used as benchmarks for index funds and ETFs.
Collectively, it’s an opportunity for fund companies to save money and index companies to make it. Why pay S&P when you can sign a cheaper licensing deal for a new index that should perform the same way? Or just have a new index built for less. That is what the fund families are thinking. Once the staff is gone, the number of ways to lower costs quickly drops.
Changing benchmarks is a nice idea. But how good is that index? How old is the index? What does it really track? How is it built? What does it measure? What are its historical results? How does it handle changes? How will it affect your money over time? Are you better off with an Old Index based fund or a New Index based fund? Will its performance stack up? Are you sacrificing performance for lower costs?
These are questions investors need to ask in this new index investing world, especially with the introduction of smart beta funds.
The benefits of low-cost funds are still important. But a little more work needs to be done these days. There are diminishing returns in the low-cost war. With discount brokers offering free ETF trades, the day isn’t too far off where only performance will matter.
While index investing has changed the way you invest, it’s still evolving and investors need to keep up with the change.