If you’re familiar with either passive investing or indexing, then we’re glad you found this guide; and you’ll be glad too.
Passive investing is presented as the most simple, yet efficient, way to invest your hard-earned cash. And it is.
But knowing the fundamentals of index investing and the implications of selecting an investment vehicle will ensure that your portfolio performs as best as possible. So, spend a few minutes with us as we guide you through the essential knowledge for a successful passive investing strategy.
We promise that your biggest concern after you leave here and start investing is how much to contribute towards retirement every month…
What Is a Passive Investing Strategy?
To understand passive investing, you must first understand market indices.
Simply put, a market index is a tool for measuring the performance of a certain market. When you hear in the news that the market is down or that this and that industry is performing well/bad, reporters refer to indices. The job of an index is to track the performance of a certain market. How does this work, though?
A market index consists of companies that best represent the market it tracks. Instead of tracking the average performance of all national defense publicly traded companies, for instance, an index that tracks this market would pick only the ones that are most fit to represent the overall performance based on some criteria.
That’s why you can also think of an index as a theoretical portfolio of securities that best represent a certain market.
Now, passive investing is the practice of following an index by investing in the securities that constitute it. When you follow an index, you basically replicate the portfolio that it consists of. Indices offer you the ability to invest in a whole market or sector without having to invest in all of the corporations that it’s made of.
While there are so many indices to choose from, only one type offers the safest returns over decades: broad-based indices.
A broad-based or total-market index is basically one that tracks the performance of a country’s economy. Some examples for the US economy are the Dow Jones Industrial Average (DJIA), the Standard & Poor’s 500 (S&P 500), and the Russell 3000.
Here are a couple of reasons that make tracking broad-based indices so attractive:
- Lowest portfolio management fees
- Minimal tax costs because of a buy-and-hold strategy
- Very low risk due to wide diversification
End of theory. Let us move on to practice now…
How Do you Track Broad-Based Indices?
Though you can track an index yourself by matching your portfolio to it, it’s unwise.
The expenses that you will incur to let someone else do the job for you make avoiding the work that you would put into this and the mistakes you could make worthwhile.
The ideal solution is to invest in an index fund. That’s basically a fund that professionals manage in a way to mirror the performance of an index. Their purpose is to produce the returns that all the stocks in the index do as closely as possible.
There are two forms that an index fund can take: a mutual fund and an ETF. Let us examine both…
You might already be familiar with mutual funds. If not, they are simply pooled money that professional managers invest for you.
You can also think of them as corporations whose main assets are money that people like you give them to invest. These businesses profit by charging a fixed percentage of the total money they manage every year.
Mutual funds can either employ an active or passive investing strategy. If they go with the latter, they are called index funds. When you invest in such a fund, you indirectly invest in the stocks of the index it tracks.
Say for example that you want to invest in the US stock market and you decide to do so by following the S&P 500 (an index that includes 500 large US companies). By investing in an index fund that’s supposed to track this index, you’d indirectly invest in all 500 stocks that the index includes.
When changes (to the companies the index includes) occur, you won’t have to do anything. The fund managers will ensure that they buy the new stocks or sell the ones that don’t fulfill the criteria anymore.
Your only job will be to keep contributing to the index fund if you want.
An ETF (Exchange-Traded Fund) is a fund that can be traded on exchanges like stocks. You can also see it as a bundle of securities; when you buy an ETF, you buy all of the underlying securities it has.
Like mutual funds, an ETF can also track an index. They mostly do, but not always.
The main difference it has with a mutual fund lies in the structure. It’s an ETF’s structure that offers a much higher level of liquidity than mutual funds. That’s because ETFs are listed on exchanges and have prices like stocks; you can sell your shares in them as soon as you buy them.
A mutual fund cannot be sold immediately after it’s bought; orders are executed once per day instead.
Mutual Funds VS ETFs: Which Is for you?
Now that you understand what both mutual funds and ETFs are, you might wonder which is ideal for index investing.
Let us, first, get something out of the way. Since you’re interested in tracking a broad-market index, the fact that you cannot trade mutual funds isn’t a good reason to go with an ETF. That’s because you likely want to invest for the long-term and not use your investment vehicle as an emergency fund.
Instead, focus on criteria like the management costs. ETFs are always perceived as the cheaper option here because most of them follow an index, while mutual funds could have any strategy.
The truth, though, is that you might find a mutual fund that follows the index you’re interested in that charges lower fees than the ETFs that also track it.
Cost isn’t the only criterion you should have, though…
How to Select an Index Fund
Choose an Index
First, choose the index you want to track.
Since you’ll be employing a passive investing strategy here, it’s obviously the broad-based indices you’re looking for. But some attributes differentiate them from one another. Not all broad-based indices are made equally.
Here are some characteristics that you should keep in mind while selecting an index…
Market Capitalization (market cap)
This is the price of all the shares a company has listed.
To categorize companies based on market cap, we have ranges; those that broad-based indices use are the following:
- Small-cap ($300 million – $2 billion)
- Mid-cap ($2 billion – $10 billion)
- Large-cap ($10 billion – $200 billion)
Indices may have set any of the above ranges as criteria for which companies can be included in them. For example, the S&P 500 only includes companies that at least have a market cap of $10 billion. While the S&P 400 includes mid-cap stocks.
When you start browsing broad-based indices, you will encounter all sorts of market caps. So, it’s good for you to know that the higher the market capitalization, the safer your investments will be. Lower small-cap stocks are inherently more risky as they lack the resources that will protect shareholders from negative sentiment and unfortunate events. Adjust based on your risk tolerance.
Another thing you should keep in mind is the number of stocks that a broad-based index includes (or its diversification level).
For instance, the DJIA has 30 stocks, while the Russell 3000 tracks the performance of 3,000 stocks. Interestingly enough, both indices are supposed to do the same thing; be a proxy of the US stock market’s performance.
But do they both provide the same level of diversification? No, and that’s why you should pay attention to this. Having your money spread across 3,000 stocks is safer than having it in 30. But at the same time, your performance may not be as good in some years.
Again, you should consider your risk tolerance and choose accordingly.
Some indices have stocks that have an equal impact on the overall performance of the index.
For these indices, no matter how big the companies or how high their prices are, price fluctuations won’t capture these characteristics. It’s like having your stock portfolio split into equal portions.
However, most indices attempt to provide a more realistic view of the market’s performance; after all, not all companies have the same size and affect the market equally. To do this, they give some weight to some stocks’ performance over that of others to track the overall performance.
There are two methods that they do this:
- Price-WeightingThis method involves adding all of the prices of the stocks together and then dividing that number by the number of the stocks in the index to calculate its price.With this method, the stocks with the higher prices have more weight in the index and, therefore, their performance affects the overall index price to a higher degree.
- Value-WeightingValue-weighting determines a company’s weight by multiplying its stock’s price by the number of its total shares.Here, the companies that have a higher market capitalization are given more weight in the index than those that are smaller.
Price-weighted indices are more simple, but value-weighted ones make for a better representation of the market. Definitely go with the latter type.
Choose a Mutual Fund/ETF
Once you have chosen your index, it’s time to select a mutual fund or ETF that tracks it.
Here are a couple of criteria to keep in mind…
The expense ratio is the annual management fee that fund managers charge in the form of a percentage of the assets under management.
For example, if a mutual fund or ETF has an expense ratio of 1% and you invest $100,000 in it, you will be charged $1,000 each year.
For context, index funds don’t charge a high expense ratio because of the minimal work that’s involved in a passive investing strategy. Following the market is, after all, easier than beating it. You should expect to find index fund expense ratios to be below 0.5%
So, if the cost for index investing is so low, why even bother with it? Well, these costs may look very low but they become significant over time. And the higher the expense ratio, the lower your returns. So, aim to find the cheapest there is.
The portfolio turnover (or turnover ratio) is the change of the assets under management of an index fund during a year, expressed as a percentage.
For example, if an index fund has an average portfolio turnover of 10%, this means that the fund managers change 10% of the fund’s holdings each year.
With index funds, the portfolio turnover is much lower than that of mutual funds that actively trade. But you should take the time to look for the lowest possible. The lower it is, the less the managers pay in fees/taxes and the greater the return that they yield for you.
In simple terms, the tracking error of an index fund is the difference between its performance and that of the index it follows, expressed as a percentage.
Matching the performance of an index fund to that of the respective index can never be done with 100% accuracy. Index funds naturally perform a little worse than the indices they track. This is due to the expenses they incur to operate, the delay to reinvest dividends, and transaction delays because of inadequate liquidity.
If an index fund has a tracking error of 2% in a given year, then that means that its returns were 2% lower than the performance of its index. The lower the tracking error, the higher your returns.
As you can see, a passive investing strategy isn’t at all difficult to employ. It’s just a bit tricky until you select the right index fund to do so. Follow the steps we outlined above and you won’t go wrong.
If you haven’t opened a brokerage account yet, be sure to go with the right broker for your needs. (link to guide).
It’s also a good idea to separate your investing from your trading activity by opening a second account. Any activity outside your passive investing strategy could fall into the “trading” territory. The least you can do is to keep these two activities separated to better track your investment performance.
Not that there’s anything wrong with trading; especially if you know what stocks to buy based on sound analysis.
By the way, if you don’t want to trade without knowing why you buy what you buy, make sure that you sign up to our email list.
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