Everyone from Warren Buffet to your favourite investment YouTuber talks about investing in index funds. Most of the advice you see online seems to say that index investing is the only way to go, and that doing anything else is just throwing your money down the drain.
There's a lot of truth to the arguments that are made in favour of index investing, but taking such a narrow stance on the topic doesn't really offer a fair comparison. Here's our take.
An index is simply a basket of investments that have been created to represent an industry or sector of the market. The most well known here in the UK is the FTSE 100. This is an index that's designed to represent the 100 biggest public companies in the UK. The full name is the Financial Times Stock Exchange 100 Index, because this index was originally created by the Financial Times.
The other major index you might have heard of is the Standard & Poors 500 (S&P 500), which is the same thing as the FTSE 100 except it's for the US and covers 500 companies. These indexes have come to broadly represent the UK and US stock markets.
So when the news states something like "the UK market was up 2% today", the likelihood is that they mean that the FTSE 100 was up by 2%.
The way these baskets are calculated is usually based on market capitalisation. That means that the biggest companies on the list have more of an impact on how much the overall index moves that the smallest companies on the list.
There are indexes for almost everything, not just the stock market. Whether you're looking at previous metals, technology stocks, small companies, mining companies, German companies, Brazilian companies or real estate, financial providers have created indexes to track the movements of almost any investment or sector you can think of.
Index investing is also known as passive investing. This is because the investment strategy is simply to invest in accordance with an index, without any attempt to 'beat the market'.
Say you want to invest into the UK stock market. Investing in a FTSE 100 index fund or Exchange Traded Fund ("ETF") would mean your investment pot would be spread across every company in that list. If the company who was 100 dropped out, it would automatically be sold, and the company that rose from 101 would be bought in its place. This is automatic and requires little to no input from you or an investment manager. The return you get from the fund is based on the average return for all the 100 holdings, weighted based on the size of the companies.
Because this process is so simple, the investment funds and ETFs are able to keep their fees very low. This is the fundamental selling point for index or passive investing. Keep the costs low and get the market average return, which is about 7% every year for the past 50 years.
Active investing aims to beat this average. Many professional fund managers believe they can 'beat the market' by choosing where to invest within a market, rather than just investing in everything.
Sticking with out FTSE 100 example, where an index fund will invest in all of the banks and supermarkets in the list, an active fund might only choose to invest in the banks and supermarkets that they think will perform the best.
There's a lot more work, time and money that goes into this, and these extra costs get passed on to the investor. This is why the fund management fees are usually higher than what you'll pay for an index or passive fund. The investment manager's Bentley won't pay for itself!
The upshot for those extra fees is that the fund has the potential to give you a better return that the market on average. This isn't guaranteed, but it is possible. The flipside is that they can also charge you more and then give you a lower return than the market average.
We have a bit of a different take on this issue. In our opinion, active management of your overall investment strategy can add significant value to your bottom line. When we say strategy, we're talking about what percentage of your portfolio you should have invested into stocks, bonds, cash and other assets.
When the stock market looks undervalued, maybe you want to have 60% of your balance invested into it. When the stock market starts to look overpriced, it might be worth reducing this to 30%.
Getting these percentages right is going to be the biggest driver of your investment returns. That's where making active choices can not only increase your potential returns, but also seek to limit how much your portfolio drops during a market crash.
Going down a level further to the actual stock selection, is where we're big fans of using passive investments. Trying to pick which individual stocks are going to perform the best is really tough to do, and arguably not possible over the long term. If we feel good about the US stock market, for example, we don't mess around, we usually just buy the 'whole market' by using a passive Exchange Traded Fund (ETF). This means we've got exposure to all sectors of the market, which tend to move in sync when the market is going up or going down.
This approach means you get the benefit of specific investment decision making based on market conditions, whilst also keeping costs down. We believe it's the best of both worlds.