Diversified Investing using Index Funds
3 minute reading time
When it comes to investments, there’s a common saying:
Diversification is the only free lunch in investing
To diversify with individual securities, one would need to buy equities and bonds from many organizations of differing sectors and capital size. For most people this can turn out to be prohibitively expensive.
Mutual funds and ETFs address this problem by pooling together money from multiple parties and purchasing securities based off some stated objective. Depending on the holdings, the fund may be considered well diversified. Some funds don’t require minimum investments which makes it easier for people to get started.
Not all funds are created equal however. Before investing in any fund, you should be informed and take a look at their prospectus to get an idea of their objectives and current assets before investing.
One way to characterize a fund is if it has an active or passive investment style. The goal of an active fund is to beat overall market trends. This means that the fund manager is often buying and selling securities to take advantage of price fluctuations. Though since it’s neigh impossible to predict market conditions, it is common for active funds to not beat the overall market.
Passive funds take a more buy-and-hold type of mentality. The core assumption is that market valuations increase over time. Therefore if a fund holds a given security over a long period of time, then is likely to result in some positive return.
Though what specific securities do passive funds buy and hold? One common category of passive funds is indexing. This is where the fund holds securities in the same weighted proportion as reported by some index. For example the most commonly known index, the S&P 500, consists of 500 of the largest stocks in the United States weighted by their market value.
For large-cap indexes (those that contains large companies), there is little turnover in the companies within the index. This makes it perfect for passively managed funds. The S&P 500 has a historical turnover rate of 4.4%.
Recall the saying about diversification being a free lunch. What would be considered one of the most diversified funds? If we’re looking at solely the US, we can consider the Dow Jones US Total Stock Market Index. This contains a market cap weighting of 4193 companies at this time of writing. That’s 8 times larger than the S&P 500.
Therefore, given the assumption that equities on average increase in value over time. A well diversified passive fund can be a great investment. These funds generally have lower expense ratios (fees) as not as much human attention is needed to maintain the portfolio.
A risk that’s unique to some index funds is tracking error. A fund may not have enough money to purchase all securities at the reported proportions. Therefore, some will perform statistical techniques to approximate the index. Also since index funds are bound by the index they’re following, the performance will be correlated and the fund may not take advantage of price fluctuations or attempt to lower drawdowns.
Disclaimer: I am not an investment analyst and this does not constitute investment advice. This information is what I’ve learned recently and I encourage you to read up on these concepts and look at the prospectus before investing.