An Index Investor follows an investment style that is based on a passively managed buy-and-hold strategy. This investment philosophy is built around the idea that the overall stock market is a great wealth creator long-term. Therefore, by investing in the market, you can gain from the benefit of these returns as opposed to selecting individual securities. An index fund or an ETF is an investment that tracks a particular market index.

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What is an Index Investor?

An index investor implements a passive investment strategy that aims to replicate the returns of a particular benchmark index. The idea behind this strategy is to benefit from the overall power of the stock market, rather than trying to beat it.

This low-risk and low-cost investment style provides instant diversification to one’s portfolio. An index fund or an ETF is a basket of stocks or other funds that mirror an index, designed to match its performance. It is often referred to as passive investing because investors do not actively look for securities or conduct fundamental analysis or research. Instead, they align an index fund or an ETF with their financial goals and take a position.

Most investors would be better off in an index fund.

Peter Lynch

Index funds are the easiest way for investors to gain exposure to the markets. Many of the greatest investors suggest that most investors should just buy an index fund, as most index funds and ETFs outperform actively managed funds. Index investing allows investors to invest in the largest companies in the world with low fees and lower risk.

Index investing allows investors to benefit with minimal knowledge, effort or hands on experience and still benefit from the power of compounding in the entire stock Market.

Although many investors passively invest in these funds, many active investors still utilize them as part of an overall portfolio. It’s important to note that investors can still actively invest in these funds. We will explain how this works.

There is a lot of theory around index investing, that suggests over the long term the market will generally outperform any stock picker. For the most part, I agree. Unless you are a passionate, disciplined, and patient active stock picker. If you can’t beat them…Join them.

What is an Index Fund?

Index funds and Exchange Trades Funds (ETFs) have rapidly changed the investment universe. An index fund is an investment that tracks a certain market index. This could be categorised as a broad market index such as the S&P 500 or the ASX 300 or an index made up of whatever the basket is trying to track. Rather than investors seeking out managed funds with higher annual fees and often underperformance, these index funds cut out the middleman and allow investors to gain the same type of exposure at a much lower cost.

An index fund manager’s job is to invest in everything that makes up that specific index and to ensure it mirrors its performance. There are a variety of index funds to choose from which can help investors design a portfolio of these funds and gain exposure to certain areas of the market without actively picking stocks there.

For example, assuming you like small-caps but don’t have the time, passion or ability to pick them. Then invest in an Index Fund or ETF that tracks the Small-Cap index and you gain exposure to the sector rather than any individual company. If you believe in the power of the US stock market or the Australian Stock market, then buy a broad market index tracking the whole market.

Both large and small investors should stick with low-cost index funds.

Warren Buffett

If you are bullish on emerging trends, or a certain thematic theme like clean energy, then why pick an individual winner, simply buy ALL the clean energy companies in one fund. Even individual styles such as Growth Investing or Value investing have funds tailored to each of these styles. Rather than finding undervalued stocks or high-growth stocks, buy them all.

Difference between an Index fund and an Exchange Traded fund?

The key difference between ETFs and Index funds is how they trade on the market. Exchange Traded Funds trade like stocks, which means you can buy and sell them like any other security. This also means they fluctuate daily like a stock. However, an index fund only transacts once a day once the market is closed. You can still place orders, but they won’t execute until after the market wraps up for the day. This brings some stability to an index fund as there is less volatility.

Index funds can have a minimum investment amount, unlike ETFs which allow investors to buy however many shares they want to. ETFs also attract much lower trading fees as some index funds can incur brokerage fees.

Both types of funds are generally low-cost, and tax-efficient and provide a range of options suitable to all types of investors. I like the convenience of ETFs to enter and exit positions. I have found the mirror of performance negligible when comparing them and typically always opt for an ETF.

There are index-tracking mutual funds, but they are often costlier in annual management fees. The whole purpose of an ETF is for investors to gain the same exposure at lower costs and still gain the returns of the market.

Why passively invest in an index fund or ETF?

I cannot write about passively managed ETFs and index funds without mentioning John Bogle, the pioneer of them and the founder of Vanguard. Bogle’s mission in life was to help everyday investors gain the returns of the stock market at the lowest possible cost. He believed that paying fees to managed funds and mutual funds was unnecessary, considering that they rarely provide greater returns than the benchmark they compete with.

The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.

John Bogle

Investing passively in an index may not beat the market over decades, but it can reap the rewards of the slow, yet powerful upward climb of the global economy. The strategy of passive investing is grounded in a buy-and-hold approach and works due to the power of compounding.

A passive index investor typically adopts the 60/40 split, which means 60% of the portfolio is held in stocks and 40% in bonds. This provides a balanced and diversified portfolio in as little as two or three positions. By investing in a handful of indexes, you can build a very diversified portfolio weighted to the areas you want to be exposed to.

Many passive index investors achieve their desired asset allocation by holding only index funds or ETFs. They eliminate the need to pick stocks, scan annual reports, conduct valuations, research, conduct quantitative analysis, rebalance, and buy and sell securities. Instead, they simply create a portfolio of low-cost, diversified funds and get on with it.

Passive investing is a great strategy for a lot of investors. Some wealth builders don’t have the time or desire to pick stocks yet understand the power of the stock market long-term.

What are the pros and cons of being an index Investor?

Like every investment strategy, there are pros and cons. No investment style, philosophy, or strategy is risk-free. None are. Passive investing does come with risks just the same as active stock selection does. Whilst there is an element of eliminating unsystematic risks associated with a specific business or industry you can not eliminate systematic risk. Whilst index funds are a lot less volatile than individual securities if the entire market tanks 30%, you’re going down with it. A portfolio that rises with the index it mirrors falls with its index.

➕ PROS	➖ CONS
Low-cost way and easy to gain market exposure.	Long-term patient investing is needed.
Easy to understand the concept of passive investing.	No chance to beat the market on an annual basis. Making average returns.
Provides diversification in a few positons.	May have years of flat to no returns which can be challenging to stick to.
Lower risk than alternative options and individual security exposure.	Limited upside potential.
Tax efficient investment structure.	Still exposed to market risk and volatility.
Low transaction costs, expense ratio and brokerage fees.	Lack of flexibility gaining exposure to rewarding areas.
Dependable long-term returns.	Newer funds are hard to exit and enter with wider spreads.
Minimal maintenance and involvement for investors.	Minimal ability to profit from short-term gains.

How to consider the index investor approach in your Philosophy?

The index investor approach is well-suited for three investment strategies. All these strategies require patience and discipline to stay on track.

The first strategy is for those who want to benefit from the stock market over the long term but with minimal involvement in active stock selection. Typically, investors will stick to a dollar-cost averaging strategy, where they allocate a certain amount of capital every month and buy during all market cycles. Dividends are usually reinvested, and this approach is a buy-and-hold strategy. Over long enough time horizons, an investor can achieve a return in line with the index it tracks.

The second strategy is for those who adopt a Core/Satellite or Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) approach. This involves aligning the bulk of the portfolio in low-cost index funds or blue chips while having tactical or “Satellite” positions in other individual securities. This approach gets the benefit of the long-term growth of the stock market while having the potential for further upside by selecting the right companies to boost overall returns.

The third strategy involves actively investing in index funds based on sectors. Certain sectors can provide meaningful returns. For example, an index fund that tracks electric vehicles, cybersecurity, artificial intelligence, and software as a service can outperform a standard broad market index. While there is a higher degree of risk, the returns can be beneficial. Investors can develop an entire portfolio of ETFs and invest in different geographies, market cap segments, and industries. Further diversification can be achieved by allocating or “overweighting” to areas of the market they are bullish on.

Having a clear investment philosophy and strategy can help determine the right style and fit aligning your risk tolerance, and time horizon with your financial goals.

What do I think about Index fund investing?

The index investing approach allows you to capture the market return with low fees, tax advantages and low risk. Regardless of your investment strategy, there is always room for an index fund or ETF in your portfolio.

Personally, I take advantage of passive ETF investing in my Retirement Fund. Due to restrictions on what I can invest in, I simply dollar-cost into 3 ETFs and reinvest all distributions. This approach has grown my Retirement Fund significantly. However, I do not invest in funds such as small caps or where I focus on individual stock selection. I believe that this approach works and will continue to work in the future, despite periods of low or no growth.

On the other hand, my active investment fund generates greater returns and is where my priority is spent. Being young, with a passion for stock picking, and disciplined, I believe that active stock selection is the best way to create wealth.

Even if I decided to sell my entire portfolio, I would still participate in an index fund to capture the long-term returns of the economic growth engine of countries. Rather than diversification, I focus on knowing what I am holding better than anyone else, which I believe is the core of my investment strategy.

It isn’t a contradiction, remember I don’t have to be either this or that, I can have both (eliminate false choices). Sometimes active stock selection has long bouts of inactivity, in the background I am still exposed to these funds and generating wealth.

In Summary…

Whilst this is not an in-depth review of indexing it should provide investors enough to understand if this investment style and belief in markets aligns with them. Remember it is still an Investment Philosophy. You believe that the stock market over the long term is a powerful growth engine, especially in established economies. Therefore, you want to participate in this capitalism long term.

The passive or index investment approach is also grounded in the belief that markets are mostly efficient. Not always but this is usually the argument. You can develop a diversified portfolio of widely different ETFs. The problem is investors end up trading them like stocks anyway. Along comes the same emotional pitfalls as active stock selection, but with limited upside potential.

Wide diversification is only required when investors do not understand what they are doing.

Warren Buffett

I believe index investing is best suited to a rather hands-off approach. If you spend all your time rebalancing and “tinkering” you may be better off selecting the best compounders and holding them. Diversification can be good and that becomes the main discussion point. Diversification may soften volatility and lower risk minimising the downside, but that impacts the potential of outside returns.

We will discuss further in other blogs the benefits of passive investing and how to build portfolios around them. But as Stoic Investors we are not looking to join the average but beat them.