What is an index?
An index refers to the statistical measure of change of a particular security market (Investopedia, 2021).
For example, UK investors use the Financial Times Stock Exchange 100 (FTSE100) to benchmark the overall UK stock market performance.
Similarly in the US, investors use the Standard and Poor’s 500 (S&P500) to assess the performance of the overall US stock market.
The number of indices out there are not limited to just S&P500 and FTSE100, there are hundreds of indices out there that measure different countries’ market.
What are index funds?
An index fund is essentially an investment product with a portfolio constructed to match or track an index, such as the S&P500 and FTSE100.
Difference between actively managed funds and index funds
Index funds have lower fees compared to actively managed funds.
Index funds adopt a passive investment strategy: which means that fund managers do not actively search for profitable companies and sell unprofitable ones.
The goal of an index fund is to mimic the risk and return of a pre-determined market, hoping that the market will outperform actively managed funds.
Problem with just looking at an index fund’s historical performance
When comparing between index funds, it is a common practice to analyse their past returns.
The problem of looking at historical performance is the past do not accurately reflect the future. Furthermore, future return often deviates by a lot from the past.
Instead, we should use the following 3 metrics to perform better analysis.
Value of asset under management (AUM)
Expense Ratio (often referred to “management fee” is the annual percentage rate that the index funds charge their investors.
On average, index funds have low expense ratio, charging less than 1% in fees (per year). These fees are calculated as a percentage of the amount you’ve invested into the fund.
To understand why management fees make such a big difference on your portfolio return, let’s illustrate it with this example:
Imagine there are only two funds offered to you:
Fund A charges 1% of management fee.
Fund B charges 0.08%.
Over 30 years, Fund A charged you 34.8% of your investment, while Fund B has only charged you 2.43%*.
*Calculation work: 1.01^30 = 1.348 (34.8%) and 1.0008^30 = 1.0243 (2.43%)
Fund A is a huge rip-off and you are better off picking Fund B, assuming both funds have identical performance. Due to the compounding effect on expenses, a fund’s management fee can be magnified.
**The rule of thumb is to pick the fund with a low expense ratio.
Value of asset under management (AUM)
It is important to look at the size of the index fund, which is often referred to “asset under management (AUM)”.
Asset under management is the amount of money the fund is currently managing.
Due to economies of scale, the more money a fund has, the better the liquidity. Index funds with high AUM are an indication of quality as it is a signal of trust given by the marketplace investors.
**The rule of thumb is: Sticking to the top 10 index funds in the world that are ranked by their value of AUM is a safe bet for selecting a quality index fund.
Tracking error is the difference between the return of an index fund and its benchmark index.
The smaller the tracking error, the better it is. You can identify the tracking error by visiting the performance section of each index fund’s website. (Simply Google “fund name” Performance)
Usually, there is a visual graph or numerical table that show its performance. To calculate the tracking error, take the historical fund performance % and subtract the benchmark index.
The best way to do this is to look at the 5 year and 1 year past returns. At the end of your calculation, you will get a range of tracking error percentage. Ex: (0.01% to 1% of error)
ExampleABC Fund ReturnS&P500 Benchmark ReturnTracking Error %1 Year12.01%12.00%12.01-12 = 0.01%5 Year20.1%20.00%20.1-20 = 1%
From this example, we can conclude that ABC fund has a tracking error range of 0.01% to 1%.
As the goal of an index fund is to match the risk and return of an index, not to beat it, a high-quality index fund should closely match the benchmark index’s volatility. The smaller the tracking error range, the better it is.
Still confused? Let’s put your knowledge into practice.
Here are 3 of my Index Fund Picks
In this exercise, I gathered all the data (expense ratio, AUM, and tracking error) to compare which index fund is better.
SPY was the first ETF listed in the US (Jan 1933).Expense Ratio (per year)Expense Ratio (30y)AUM (Jun 29, 2021) USDTracking Error0.0945%2.9%370.4B0.1% to 0.3%
One of the funds that has exponentially gained popularity in the past 10 years.Expense Ratio (per year)Expense Ratio (30y)AUM (Jun 29, 2021) USDTracking Error0.04%1.2%285.3B0.04% to 0.05%
*There is a hidden fee of 0.01%: it is referred to “discount/premium.” (0.03% + 0.01% = 0.04%)
It was one of the first available index funds offered to investors that tracked the S&P500.Expense Ratio (per year)Expense Ratio (30y)AUM (Jun 29, 2021) USDTracking Error0.04%1.2%231.8B0.02% to 0.04%
Before you invest in any index funds, create a table like above and highlight each index fund’s advantages and disadvantages, then decide on which one you feel is best fit for your portfolio.
As VFIAX has the lowest tracking error and expense ratio, I would personally pick that over the others. Although SPY has the largest AUM, I prefer picking the lowest cost index fund over a larger fund size.
Which one would you pick out of these three choices?
What are your top index funds picks?
Let me know down in the comments or DM me at Instagram (@Leinvests)
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. I am not affiliated with any securities brokerage or investment company and I am not rewarded for mentioning any securities in this blogpost.