This post is the third in a series of four in which I cover all you need to know about one of the greatest inventions in finance – index funds. See also:
- Index funds part 1: What is a stock market index?
- Index funds part 2: What are index funds?
- Index funds part 4: How to invest in index funds
In the first two articles, I explained what stock market indices and index ETFs are. This post will discuss some reasons why index funds are the ideal long-term investment product for the average person.
Diversification
We have all heard of the old adage “don’t put all your eggs in one basket”, and this is especially important when investing your savings. We often hear of massive asset price hikes in the news, such as that of Bitcoin in recent years, and dream about where we would be now if we had put all our savings into that asset back then. What does not make for sensational news, however, are assets which have had price declines, in which investors have lost money in. When you use your savings to buy shares in a single company, you are placing a bet that it will do well (or rather, that its share price will increase). If it does, good for you. But on the other side of the coin, a myriad of reasons may cause the share price to decrease, possibly even to zero. For example, a fire in one of the company’s factories, the CEO getting into a car accident, or accounting fraud. In such cases, you stand to lose all of your savings.
The risk of such freak incidents occurring to individual companies is known as idiosyncratic risk. One way to reduce the idiosyncratic risk that your savings are exposed to is diversification. Instead of buying shares in one company, you could divide your savings to buy shares in two, or ten, or even five hundred different companies. This way, if one company’s CEO gets into a car accident and another company’s main factory burns to the ground, the overall impact on your savings will be minor.
Now, for someone of modest means, it would be highly impractical to invest in five hundred companies. For one, the time taken to buy shares in five hundred different companies would be quite substantial. Furthermore, dividing our limited savings into five hundred separate pools will not leave each pool with much, resulting in relatively high transaction costs.
One solution to this is to buy shares in an index ETF, which then invests in a basket of companies on your behalf (based on the constitution of the index). This achieves significant diversification without requiring any extra work on your part.
As of 22 April 2021, the top three holdings of the SPDR S&P 500 ETF Trust are:
| Name | Weight |
| Apple Inc. | 5.95% |
| Microsoft Corporation | 5.54% |
| Amazon.com Inc. | 4.05% |
This means that even if Apple, Microsoft, and Amazon were to all go bankrupt at the same time and their share prices were to suddenly fall to zero, you would lose less than 16% of your investment. Imagine if you had put all your money into one of those companies!
Some people want to invest in the so-called Blue-Chip stocks, which are large and reputable companies. They perceive these to be safe options and they are not wrong. For instance, it would be quite hard to imagine that DBS Bank, the largest bank in Southeast Asia and also a familiar name to all Singaporeans, would fail in the foreseeable future. But why bet on one Blue-Chip stock when you can bet on many? Investing in an index ETF is essentially spreading your investment over many Blue-Chip stocks. The Nikko AM Singapore STI ETF, for example, invests in 30 of the biggest companies listed in Singapore, including DBS Group Holdings; Oversea-Chinese Banking Corporation; United Overseas Bank; Singapore Telecommunications; and Jardine Matheson Holdings.
Market performance
This section considers whether stocks chosen by yourself or professionals can get better returns than index ETFs. The first point to be made is that stock market indices measure the average performance of the stock market. That is to say, investors in that stock market (in particular, investors in those large companies constituting the index), on average, must have a return equal to the return of the stock market index. How confident are you of beating the average? Keep in mind that you are playing against big companies with powerful computers and full-time analysts.
The second point that I would like to make relates to the Efficient Market Hypothesis (EMH). Think about it this way: suppose that the price of toilet paper is going to double tomorrow (due to a large shipment being lost to a storm). Surely, we would all be out buying whatever toilet paper we can get our hands on today. This large surge in demand would prompt sellers to raise the price of toilet paper. The price of toilet paper would then be raised until the hoards of buyers see no further need to buy toilet paper today. This happens when the price of toilet paper has doubled, since they are now indifferent between buying today or tomorrow. Therefore, an expected rise in the future price of toilet paper has resulted in a rise in price of toilet paper today.
The Efficient Market Hypothesis, loosely, refers to this phenomenon. Any information about the future earnings of a company is reflected in the current stock price. If a company is likely to do very well in the future, then people would want to buy its stock, resulting in a rise in price. If a company is at risk of failing, then current investors would want to sell its stock, resulting in a fall in price.
Based on the EMH, I am of the personal opinion that managed portfolios based on algorithms or AI are unlikely to outperform stock market indices over the long run. Even when back-testing is carried out and demonstrates consistent historical outperformance, it does not necessarily guarantee that the trend of outperformance will continue in the future. If a foolproof algorithm for making lots of money existed, surely it would be exploited until such opportunities no longer exist? Indeed, hindsight is 20/20.
Burton Malkeil (Professor of Economics at Princeton University) is a strong proponent of the EMH. You can read one of his articles on the topic here. It includes a section discussing the empirical evidence that investment professionals tend to underperform the stock market indices in the long run.
Fees
Take a look at a simple comparison of fees between three index ETFs and three digital platforms offering managed investment portfolios:
| Investment product | Fees |
| SPDR S&P 500 ETF Trust (SPY) (Index ETF) | 0.0945% per annum |
| Vanguard FTSE 100 UCITS ETF GBP (VUKE) (Index ETF) | 0.09% per annum |
| Nikko AM Singapore STI ETF (G3B) (Index ETF) | 0.30% per annum |
| Syfe (Managed portfolio) | 0.65% per annum (for amounts under S$20,000) |
| Endowus (Managed portfolio) | 0.60% per annum (for amounts up to S$200,000) |
| StashAway (Managed portfolio) | 0.8% per annum (for first $25,000; excluding ETF management fees) |
The fees for the three index ETFs range from 0.09% to 0.30% per annum. The Nikko AM Singapore STI ETF’s fee is on the higher side compared to the other two, but even then, it is only half of the fee of the cheapest managed portfolio. The fees for the three managed portfolios range from 0.60% to 0.8% (assuming modest investment amounts of under S$20,000).
But how significant are fees really? Let us run an experiment. Suppose Ali invests $5,000 in an index ETF charging 0.09% per annum (the cheapest of the three index ETFs mentioned) for 20 years, while Bala invests $5,000 in a managed portfolio charging 0.60% per annum (the cheapest of the three managed portfolios mentioned) for 20 years. Now, suppose that the return for both investment products is about 8% per year (which is the historical annual average return of the S&P 500 excluding dividends).
| Investor | Initial investment amount | Investment product | Fee | Average annual return | Effective net annual return | Value after 20 years |
| Ali | $5,000 | Index ETF | 0.09% | 8% | 7.91% | $22,919 (5,000×1.079120) |
| Bala | $5,000 | Managed portfolio | 0.60% | 8% | 7.40% | $20,848 (5,000×1.074020) |
After 20 years, Ali would receive $22,919 while Bala would receive $20,848. That means that the difference in fees (0.09% versus 0.60%) would, over 20 years, have resulted in more than 10% difference in final value.
A warning
Index ETFs are not perfect. Every investment comes with some risk. Here are two types of risk to be wary of.
Country risk
An investment in an index fund is a bet on the economy of that country. As long as the economy hums along fine, the share price of the index ETF should be sustained. A word of advice would be to stick to major stock market indices of developed economies. The three stock market indices that I have brought up repeatedly in this series of articles are such examples. You should also spread your bets across different countries, as unfortunate things can sometimes happen to individual economies.
Timing risk
Even if a stock market tends to do well in the long-run, the timing of buying and selling may be risky. If you had invested in a major stock index fund in 2007 (just before the Great Financial Crisis) or in 2019 (just before the Covid-19 pandemic), you would have seen the value of your investment plunge quite rapidly. If you needed to use your savings urgently, you would have had to sell your investment at a steep loss. The ways to reduce this timing risk are to (i) buy in small batches over a period of time, as well as (ii) ensure that you are prepared to keep your savings in that investment for a long period of time. That is to say, you do not foresee any need to withdraw the money soon.
To sum up
- Investing in an index ETF is safer than investing in an individual stock due to diversification.
- Empirical studies show that managed funds tend to underperform index funds after fees.
- Investing in an index ETF is more efficient than investing in a managed portfolio or mutual fund due to lower fees.
Are index funds for you? If so, read the next (and final) article in this series to find out how you can invest in index funds.
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