My friend recently asked me if investing in an index fund is a good way to get started. First, let’s agree on one thing…just making the effort to start investing is a good start. Congrats on that one.
Index investing has gained popularity for being an easy and cost effective way to get into the market. But now the supply of index funds has exploded, so how do you choose? For all investors, it’s important to understand fees, or expense ratios, and portfolio composition. Fees are pretty straightforward (avoid funds with high expense ratios relative to returns) so I’m going to focus on portfolio composition and why it matters.
The Problem
Let’s take one of the more popular index funds and break it down — VTSMX.
The Vanguard Total Stock Market Index Fund (VTSMX) chooses the amount of a given stock it holds based on market capitalization, or the total market value of a company’s outstanding shares. The fund holds a higher percentage of Apple shares than Walt Disney Co. shares because Apple, as a company, has a higher valuation. So more weight is given to large-cap stocks than to small and mid-cap stocks. But wait, studies have shown that over the past 20 years small and mid-caps have beaten large caps in performance. So if most people invest in these types of index funds and you want to maximize performance, why don’t large funds weight small and mid-cap stocks heavier? Well being popular comes with an added cost.
As fund assets increase, market impact costs increase too. Market impact costs are an added cost caused by price changes when a buyer or seller of stocks makes a large transaction. VTSMX has fund assets of $672.4B and holds 3610 different stocks. Having this much money to work with makes it difficult to hold higher weights of small and mid-caps because fund managers can influence prices when making large stock moves (i.e. if you own a ton of shares of a smaller company and try to sell, the price will go down before you can get rid of them all, hurting your profits or increasing your loses). Within the fund, Apple makes up 2.8% of the fund. I know what you’re thinking, “That’s nothing.” But 2.8% of $672.4B is $18.83B! And with Apple’s market cap approaching $1 trillion, the fund manager is able to make adjustments without causing problems.
The Solution
What I told my friend is you’re young so you have a long time before you need the money you’re investing. Most people are worried about higher volatility, but what is volatility really? Volatility = Risk. More Risk = More Potential Reward. Remember, the goal is long-term growth. You use indexes to fit in and get close to the market, not to outperform. Last time I checked, no one got wealthy from fitting in.
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