Why Experts Advise to Invest in an Index

Why Experts Advise to Invest in an Index

Index investing is a passive investment strategy that attempts to generate similar returns to a broad stock market equity index.  In recent times, index investing has become more and more popular for a number reasons outlined below.  Warren Buffett, CEO of Berkshire Hathaway and possibly the most famous investor in the world, is a major proponent of this passive investment strategy and recently said that he has instructed the trustee in charge of his estate to invest 90 percent of his money into an index for his wife after he dies1.

Performance

Investment fund managers fail to beat the index net of fees 97% of the time.  At first reading, that might seem odd as people generally assume that fund managers are the experts and know the right balance of stocks, bonds and GICs to invest in to provide optimum returns for any given investor’s risk profile.  But the simple fact is that index returns are irrefutable over time.  Warren Buffett remains bullish on index investing and in February this year said, “I think it’s the thing that makes the most sense practically all of the time.”  Buffett, the famed billionaire investor, also added that even his two chief stock pickers at Berkshire Hathaway, Ted Weschler and Todd Combs, have failed to beat the S&P 500. 1

Looking at Canada’s S&P/TSX 60 stock index: over 10-year periods since inception (January 29, 1992) to August 19, 2019, the index has produced a positive return 99.87% of the time and the average annual return for ten year periods is 6.72%.  These time period, of course, includes both bear and bull markets but the fact is that over longer periods of time, indexes almost always produce positive returns.  Buffett told CNBC’s Squawk Box in February of this year that if somebody invested $10,000 in the S&P 500 back in 1942, it would be worth $51 million today.

Diversification

 An index fund is made up of a broad portfolio of different individual securities and helps investors lessen the risk that comes with investing in just a single security.  For instance, the S&P/TSX 60 is a stock market index comprising 60 large companies across ten different sectors listed on the Toronto Stock Exchange.  The performance of these 60 different stocks will fluctuate and vary over time, but when your money is spread out among so many separate assets, these ups and downs are smaller.  If you put all of your principal in two or three different stocks of your choice, there is a chance that they will lose some, or all, of their value. Investing in an index, such as the S&P/TSX 60, the odds of all 60 companies losing all of their value are extremely slim. If a couple of stocks in the index lose value, there are a number of others from different sectors to pick up the slack and offset the loss.  Although diversification does not guarantee against loss, it is one of the most important components of reaching long-term financial goals while minimizing risk.

Cost Effectiveness

There are two styles of investment management: active and passive management.  When investors are working with financial advisors, they will often be directed towards managed funds that fit into the active management category.  Active management involves the fund manager putting his or her skills and expertise to the test by trying to choose the right securities, at the right time, in order to outperform the market.  As mentioned earlier, though, this is often in vain as many of the top stock pickers in the world fail to beat the index over time net of fees.

 Due to actively managed investment funds requiring more hands-on research and because they experience much higher trading volumes, their expenses are naturally higher.  A common investment fund fee structure is known as “1: 20”.  The "1" means 1% of assets under management and refers to the annual management fee which is charged by the hedge fund manager for managing the assets, regardless of performance.  The “20” is a 20% performance fee that the fund charges if it achieves a level of performance above a certain threshold2.

 On the other hand, passively managed funds (which include index funds) do not attempt to beat the market.  Instead, they look to match the risk and return of the stock market as a whole or a segment of it. Trading volumes are considerably lower as the investment manager will only need to trade periodically to rebalance the portfolio.

Next Steps

 When looking to invest in an index, investors should carefully review the offerings in the marketplace, look to protect their principal, leverage their investment, and compound returns over longer periods where possible to maximize returns.

Wisdom Mutual Fund™ invests in a Participating Bank Note (a “PBN”) with a principal amount of $1,000 per Unit.  Such principal is fully guaranteed by a Canadian Schedule 1 Bank, if held to maturity in ten years.  The PBN provides a participation rate of 100% of the positive price return of the S&P/TSX 60 index with no cap on returns, if held to maturity.  Leverage is provided by reduced cash outlay with 50% due on acquisition and 50% due at maturity (10 years) which provides leveraged equity index investment on 100% of Unit Issue Price with only 50% paid upfront.  The Fund charges no annual management fees or performance fees. For more information see www.wisdomsi.ca

 

1  https://www.cnbc.com/2019/02/26/warren-buffett-wants-90-percent-of-his-estate-invested-in-index-funds.html

2  https://www.investopedia.com/terms/f/fee-structure.asp

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