Financial Blog

In his book “The Little Book of Common Sense Investing“, Warren Buffet, one of the most prolific and successful investors of our time, said that “A low-cost index fund is the most sensible equity investment for the great majority of investors,”. He went on to continue, “By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.”

You might wonder if it’s possible to beat the most seasoned investors in the stock market—the answer is yes. Sure, some traders make some big gains over a short period of time, but it’s really hard to sustain that for a very long time especially if you don’t have the time to study the fundamentals of each company.

The philosophy of investing in index funds is that you won’t actually beat the market. Rather, you’ll mirror it. This is advantageous for passive investors since you’ll basically own everything in that index which reduces risk compared to stock picking. Nifty isn’t it?

Now, let’s take a deep dive further into the world of index funds…

What are Index Funds?

Index funds are a type of mutual fund whose holdings match or track a specific market index, typically made up of stocks and bonds. How it works is that the fund invests all its components included in the index they track. In the case of the Philippines, there is only one index available to track — The Philippine Stock Exchange index (PSEi). 

Index funds are hands-off. It’s relatively easier to build a diversified portfolio earning solid returns using mostly this investment type because Index Funds don’t try to beat the market, or earn high returns compared to market averages. Instead, these funds try to be the market—buying stocks of every firm listed on an index to mirror the performance of the index as a whole. 

They can also help balance the risk in an investor’s portfolio, as market swings tend to be less volatile across an index compared with individual stocks.

Index funds or mutual funds are great if you:

• Are looking for a long-term investment.
• Are putting in a lot of money into the account so it can add up.

What’s in it for me if I invest in Index Funds?

• You spend less time researching individual stocks. Instead, you can rely on the fund’s manager to invest in an index that already includes stocks you want to invest in.
• You spread out your risk among different company stocks. Most indexes include dozens or even hundreds of stocks and other investments, and the diversification leaves you less likely to suffer big losses if something bad happens to one or two companies in the index.
• It makes diversifying your investments easier. You can buy stock index funds and bond index funds, which cover the two big parts of most people’s investment strategies. But you can also buy more focused index funds that drill down into certain parts of the financial markets.
• It’s cheaper. Index funds are usually far less costly than alternatives like actively managed funds. That’s because an index fund manager just has to buy the stocks or other investments in an index — you don’t have to pay them to try to come up with stock picks of their own.
• Less tax. Index funds are quite tax-efficient compared with many other investments. For instance, index funds don’t have to do as much buying and selling of their holdings as actively managed funds, and so index funds avoid generating capital gains that can add to your tax bill.
• It’s a lot easier to stick with your investing plan. When you use index funds, you can automatically invest month after month and ignore short-term ups and downs, confident that you’ll share in the long-term growth of the market.

How do Index Funds Work?

An index fund tracks the performance of a market index. It has a fund manager, whose job is to monitor the index being tracked and buy or sell when the index makes changes to its portfolio. This makes sure the index fund continues to “match” the index itself. This is considered passive management because there is no research involved and equates to lower fees for the investor, unlike mutual funds.

When an investor purchases shares of an index fund, they aren’t purchasing the entire index – that would be expensive. They are, instead purchasing a percentage of all the stocks in that index.

What are the advantages of investing in Index Funds

• You spend less time researching individual stocks. Instead, you can rely on the fund’s manager to invest in an index that already includes stocks you want to invest in.
• You spread out your risk among different company stocks. Most indexes include dozens or even hundreds of stocks and other investments, and the diversification leaves you less likely to suffer big losses if something bad happens to one or two companies in the index.
• It makes diversifying your investments easier. You can buy stock index funds and bond index funds, which cover the two big parts of most people’s investment strategies. But you can also buy more focused index funds that drill down into certain parts of the financial markets.
• It’s cheaper. Index funds are usually far less costly than alternatives like actively managed funds. That’s because an index fund manager just has to buy the stocks or other investments in an index — you don’t have to pay them to try to come up with stock picks of their own.
• Less tax. Index funds are quite tax-efficient compared with many other investments. For instance, index funds don’t have to do as much buying and selling of their holdings as actively managed funds, and so index funds avoid generating capital gains that can add to your tax bill.
• It’s a lot easier to stick with your investing plan. When you use index funds, you can automatically invest month after month and ignore short-term ups and downs, confident that you’ll share in the long-term growth of the market.

What are the disadvantages of investing in Index Funds

• Returns are not guaranteed.
• You don’t control what stocks are part of the account.
• Your return on investment (ROI) will only reflect the market average. That means your return is the average of all stocks in the index, whether they are gaining or losing.
• When the market falls, the funds follow suit. And there is no way to protect one from the slowdown unless you pull out of it.
• Some Index Funds don’t give out dividends, so you only gain when their net asset value increases.
• The Philippine index funds have very expensive fees compared to index funds (that are tracking foreign markets, admittedly of course) being offered in other countries.

What are some of the Index Funds available to me?

Index funds can be classified into different types. If you want to invest in index funds in the Philippines, here are some of the options available to you:

• Mutual Fund An investment fund that features pooled money from investors that will be managed by a professional fund manager. 

• UITF Follows the same investment structure of mutual funds (pooled investments) but are offered/managed by banks. 

• ETF An Exchange Traded Fund or ETF is a collection of investments that tracks indexes of specific exchanges (PSEi, NYSE, NASDAQ, etc.,) and can be traded in real-time. In the Philippines, there’s currently only one type of ETF, the First Metro Philippine Equity Exchange Traded Fund (FMETF)

• Personal Equity & Retirement Account (PERA) Not exactly a category or type of index fund, rather, PERA it’s a retirement program that allows investors to pick certain investment vehicles that include index funds.

• Feeder Fund A type of fund that is structured to invest a majority of its assets in a single collective investment scheme (target fund). These target funds can be UITFs, Mutual Funds, or ETFs.

Compared to the local market, Index Funds in overseas markets such as the US tend to be more diversified. In the Philippines, the PSEi is the only index available for tracking whereas in the US,  there are indices such as S&P 500, NASDAQ, Dow Jones Industrial Average, and more.  

For investors looking to invest overseas, here are some examples of the top-performing index funds  available:

• Vanguard Total Stock Market Index Fund (VTI)
• Invesco Trust Series 1 Nasdaq-100 ETF (QQQ)
• Fidelity ZERO Large Cap Index Fund (FNILX)
• SPDR S&P 500 ETF Trust (SPY)
• iShares Core S&P 500 ETF (IVV)
• Vanguard Total International Stock Index Fund (VXUS)

How do I invest in Index Funds?

The key to successfully investing in index funds is by finding the right broker/institution but this may also differ based on what kind of investment you are planning to enter into. Generally, these can be either private or public entities that offer Mutual Fund, UITF, ETF (FMETF), Personal Equity & Retirement Account (PERA), and Feeder Funds among the investment instruments. 

Take for Example Security Bank’s UITFs: The SB Equity Index Fund, and the various Feeder Funds available which allow investors to invest for as little as P10,000 in the local market for the former, and the global market for the latter, with one of the main requirements being that the investor must have an existing account before applying for a UITF account.

Final Thoughts

If you’re looking for a long-term investment, index funds are a good choice, especially for passive investors. It gives you the opportunity to spend less time picking stocks and spread risk. Investing in index funds doesn’t stop you from seizing opportunities on individual companies you really believe in, though. 

A good rule of thumb is to invest consistently in index funds—whether lump sum or peso cost averaging. This will give you relatively higher returns over time without the risk of losing all your hard-earned money. Never underestimate the power of compounding.