From index-tracking funds to benchmarked DIY portfolios, there are several options for investors who are looking for returns in the long term
Stock index investing is an effective strategy to manage risk and gain consistent returns over the long term.
Investors opt for this buy-and-hold strategy to mirror the performance of a specific index by purchasing several component stocks of the index, by investing in an index mutual fund, or picking an exchange-traded fund (ETF) that tracks a specific index.
Many stock index investors look at the S&P 500 stock index as the most common benchmark against which to evaluate performance as a bellwether for the US economy, in addition to the Dow Jones Industrial Average stock index.
For broad exposure to the European economy, investors can turn to the Euro Stoxx 600 and Stoxx 50 stock index, or opt for individual country indices: Germany’s DAX, France’s CAC40 or the UK’s blue-chip FTSE100.
Further afield, Hong Kong’s Hang Seng, FTSE China A50 index and Tokyo’s Nikkei stock index offer investment opportunities for global investors who want to benefit from the region’s growth, and consequently from its financial market, but don’t mind their volatility.
There are several approaches to making money from indices that investors can choose from, depending on their risk appetite.
They can opt for active stock index investing by building their own portfolio through DIY stock picking, or resort to the low-cost, low-hassle passive approach of index mutual funds or exchange-traded funds.
Index mutual funds
Mutual funds are the most popular indirect method of stock index investing, and the most suitable for novices.
Warren Buffett has famously said a low-cost S&P 500 stock index fund is the best investment most Americans can make.
If Warren Buffet, one of the richest men on the planet, with a personal wealth estimated at $90bn, touts the benefits of investing in low-cost index funds, it’s worth paying heed to his advice.
The performance of index mutual funds, which match and track the performance of an entire stock market index, often beats that of the vast majority of actively managed funds headed by star asset managers.
Unlike actively managed funds, index funds usually have lower management fees and are more tax-efficient because they make less frequent trades.
How to invest in indices
Passive funds came onto the scene in the 1970s, when American investor John Bogle launched the first stock index fund.
Bogle's fledgling fund was widely mocked for pursuing average returns at a time when managed funds aimed to beat the market. Bogle had the last laugh, however, because today the Vanguard 500 Index Fund has nearly half a trillion dollars in assets under management.
For many investors, whether large or small, the average performance of stock index funds is more than adequate, as long as it comes with minimal fees.
For example, passive equity funds in the US cost an average of about 10 cents a year per $100 of assets, compared with 70 cents for active funds. Hence their popularity for investors seeking to make money with indices.
In contrast, their actively managed rivals have underperformed the broader market in the past 20 years, while continuing to charge investors premium fees.
In September 2021, Morningstar Inc reported that passive US equity funds had $12.5bn of inflows and active funds had $20bn outflows.
Stock market indices also help diversify investments across several companies and industries. For example, an investment in an S&P 500 index fund provides exposure to 500 companies at once. Likewise, a fund that tracks the CAC40 will provide exposure to all 40 companies of the highly diversified French index.
However, stock index fund investing comes with a few drawbacks.
Returns may be hit if one large company listed on an index reports dismal results that are unique to its business, but may still take down all the stock prices in its sector.
Another downside to indexes is that investors are exposed to all the companies on that index, without being able to opt out of a particular stock on moral or personal grounds.
Invest and forget
Still, passive funds remain an attractive portfolio strategy for individual investors because they are a simple, low-cost way to invest cash and “forget about it”.
Passive funds began to gain popularity in the 1990s with the introduction of ETFs, which are a basket of securities that trade on an exchange, just like shares.
Index ETFs are exchange-traded funds that track a benchmark index such as the S&P 500 or the Euro Stoxx 50.
They work just like index mutual funds. However, unlike mutual fund shares, which can be sold at just one price each day, index ETFs can be bought and sold throughout the day on a major exchange, just like stock.
Exchange-traded Funds
The popularity of ETFs coincided with the rise of the internet, and financial websites that gave small investors the tools to compare the performance of funds.
The financial crisis of 2008, when many investors got their fingers burnt by the dismal performance of managed funds, further enhanced the attractiveness of low-cost passive funds such as index ETFs.
Like index mutual funds, index ETFs offer instant diversification through a tax-efficient, cost-effective investment, while being less volatile than funds that target specific sectors.
But they also have disadvantages. Because ETFs often focus on large-cap stocks, they may offer limited exposure to mid- and small-cap companies that may offer better growth opportunities.
DIY stock-picking
Although not for the faint-hearted, do-it-yourself investing is a cost-effective way to gain active exposure to indices without the large investment outlays or high fees charged by managed funds.
While the diversified nature of index mutual funds and ETFs may be a buffer against risk, these investments are unlikely to yield meteoric returns like a individual tailor-made portfolio, where wise picks can bring a generous pay-off.
Picking individual stocks and building up a diverse portfolio requires a considerable amount of time because it involves researching company fundamentals and buying stocks that meet certain investment criteria.
Still, creating one’s own index portfolio has several advantages. Unlike index funds, the risk of large-stock overweighting is removed, so investments are always well diversified.
Index funds also overweigh expensive stocks because the more expensive the stock, the greater their share in the index. This means that investors often end up holding more expensive shares than favourable stocks.
There’s no such risk from made-to-measure portfolios. Many online trading platforms offer “dummy” portfolios with which would-be investors can practise before venturing into real-world trading. These portfolios trade exactly as if they were real, but without exchanging any money, which means there are no losses in case of mistakes.
There are also stock-picking services designed to help investors choose their portfolio. Some stock-picking services can be expensive because they employ investment professionals who analyse stocks they recommend to members. Others work as automated stock screeners and can be a cost-effective solution for novice investors.
One of the main things to consider when trading shares as a DIY investor is how it will cost in charges, which can ramp up considerably.
The main ones to look out for are an account fee – which may be charged on a monthly, quarterly or annual basis – as well as inactivity fees if investors don’t make a certain number of trades within a set period. And, of course, there are fees for buying and selling shares.
A DIY stock-picker’s portfolio should be evaluated against a benchmark, which is used as a tool to assess the allocation, risk and return of the portfolio. Benchmarks are usually created using either unmanaged indices, mutual funds or ETFs as a reference.
