Index Funds: What They Are And Why Invest In Them

Index Funds: What They Are And Why Invest In Them
A while back I opened an Index fund. And so far, I've been satisfied with the results. So I thought it might be a good idea to share what an Index fund is and why I chose it.

So what is an Index fund?

Index funds are basically mutual funds invested in stocks (equity). While there are a lot of different types of equity funds (some focus on growth, others on value, etc.) An index fund differs from them because the fund manager doesn't pick the stocks. All the fund manager does is exactly copy the stocks of a particular index (in this case the Philippine Stock Exchange Index - PSEi), down to how each stock is weighted.

For a simplified example: if the PSEi is composed of PLDT, SMC, Philex Mining, and JFC, then the fund manager would buy all four stocks and nothing else. And if PLDT had 50% weight on the index then half the fund would be used for buying PLDT stocks. And if SMC had only a 2% weight on the index, then only 2% of the fund will be used to buy SMC shares.

(Weight, by the way, is a measure of how much impact a stock has on the index, and it is determined by PSE. The information is available on their official website).

So why did I choose this type of mutual fund?
  • It has a relatively low annual fee of 1.5% (compared to 2% or more in other  funds). If I find an index fund (or any high performing fund) with only 1% annual fee, I might move to that.
  • Despite active management, not every fund beats the market. And the higher the annual fees, the harder it is for the fund to beat the market. This is because the fee takes away from the returns. So if a fund has a 2.5% fee, it has to beat the market by 2.5% for the investor to break even. A fund with a lower 1.5% fee in contrast, will already post a 1% profit at that point for the investor.
  • The small difference seems like nothing. But for long-term investors, it should be noted that this can compound and take away from the lifetime return on investment of what you put in the fund.
  • In general, if the market is bullish, equity funds thrive. And if the market is bearish, they wilt. Fund managers may actively hedge to cut losses. But over the long term the market is the main factor that will dictate the fund's value. Since I'm at the start of a long term investment plan, I saw no need to hedge and accept lower returns or to be more risky and chase slightly higher returns.
  • Lastly, I checked and the Index fund was doing better than my previous equity fund. And better than all the other equity funds my bank offered (which had higher fees too). So it was a no-brainer for me to switch.

There are a few downsides to this however:
  • It's better than a lot of other funds, but there are a few funds better than it as well.
  • There's no safety net. If the market plunges, so does your investment. For actively managed funds, there's at least the chance that the fund manager can pick stocks that won't lose so much value.
  • If there are stocks out there that are obviously over-valued or under-valued, there's no room for them in the fund. It's a very exclusive strategy that can't co-exist with any other strategy. 
  • Not all index funds have the exact same performance as each other or even the PSEi. It's a sign that they have a slightly different composition. Small differences can be attributed to the annual fees and slight difference in composition (ex: the market has 892456372 shares of SMC being traded, but the fund has 200 - not exactly in direct proportion, right?). And investors still need to check that there aren't large differences in performance from the PSEi.


So who might like this approach? Well it's a personal choice, really. But if you're a long-term investor and you hate high annual fees, then this can be an option. Of course, this approach is not for everyone, and I encourage everyone to do their research on different funds before choosing which one to invest in. 


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14 comments:

  1. With which company or bank did you get an index fund from?

    ReplyDelete
    Replies
    1. Hi Claudine!

      I got mine from BPI. No other bank seems to have an index fund, though. But there are at least two other companies to choose from: Philippine Stock Index Fund Corp. and Philequity PSE Index Fund Inc.

      Delete
  2. Nice blog. I think Index Fund works best is developed countries or big Indices like the S&P 500 etc. But in Philippine setting, based on historical accounts, a good managed mutual fund beats PSEi index many times over. If the Philippine continues to improve, this may change soon.

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    Replies
    1. Hi lagawan,

      Thanks!

      I did a comparison and yeah, it certainly looks that way. Another factor are the fees. They're basically the same as the managed funds. In the U.S. specifically, there's a huge difference in fees.

      Delete
  3. Hi Carlos, appreciate the information you provided. You mentionend you got your index fund from BPI, just want to clarify if this is the UITF or Mutual Fund index fund? My understanding is you got the MF. BPI is offering both, but I'm thinking of getting the UITF.

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    Replies
    1. Hi Jaclyn,

      The one I got and talked about in this article was the mutual fund.

      Although I actually have both now. somehow it seems the mutual fund performs beter than the uitf. However the UITF is more "dependable" - sometimes the MF Index is "closed" and cannot be invested into for months.

      Also, the UITF will take practically any amount and invest it completely. The MF has a high share price now (~Php900 per unit I think) and won't let you buy fractional shares - so its slightly less conducive for cost averaging.

      Delete
  4. Hi Sir, thanks for the updates.
    Ya, PSIF now has a high price. Should we continue to buy
    at the current price or wait for pullback? This is for long term investing by the way (+5years).
    Thanks for the inputs

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    Replies
    1. Hi Dara,

      For me personally I just cost average.

      If you think about it, today's high prices could be a bargain compared to prices three or five years form now.

      Also, the price after the next pull back might still be considered high, if a big correction happens a few months or a year from now.

      In general though, it is more profitable to buy on pull backs. You just need to be vigilant so that you are always aware when a pullback is happening. Also, waiting for the "bottom" of the correction would also maximize your profits.

      But if you're busy or aren't particularly obsessed with your portfolio, you can cost-average over time and avoid the hassle. It will still be profitable.

      Delete
    2. Hi sir, thanks for the inputs. I'll continue with the cost averaging.
      How about FMETF? Would you recommend FMETF?

      Delete
    3. Thanks sir... How about FMETF which also tracks the index but tradable, would you recommend it?

      Delete
    4. Hi Dara,

      I don't have any experience with it. But I do like it. In fact, I had thought about moving my investment there but ALFM PSIF got "better" and opened up again to new subscriptions.

      Delete
  5. Hi. I bought FMETF shares. Started last 10/15 it's appreciating now, it started may this year. I just let it ride the volatility wave but honestly, I still don't fully understand the logic behind etfs I know that it tracks PSEI, so does it mean that if psei is up or down, etfs follow? And since it has the 30 blue chip stocks, and the price appreciates, I am just basically diversifying my investments even I have other blue chip stocks separately bought in my portfolio now?

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  6. I just want to point out that PASSIVELY managed index funds here in the Philippines still charge horrendously high management fees (1% for PhilEquity Index Fund, which is already the lowest).

    Vanguard's fees are .05%!!! Note the decimal point and the decimal place - PhilEquity is 20X higher than the .05%.

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  7. Hi. I'm 23 yrs old and currently working as a call center agent. I really am interested in investing. I haven't started yet since I know that I have little knowledge with this matter. Just want to ask before I start investing, what would you recommend to be my starter, invest on index funds or peso cost averaging? I've read 2 books about investing from Anthony Robbins and he's suggesting that people should invest on index funds. However, I want to know is it smart for me to buy index funds here in the Philippines? Or should I just focus on PCA?
    Thanks!

    ReplyDelete