Thoughts on Indexing

Indexing or buying index funds provides investors with a well-diversified funds, usually at a low-expense ratio. Exchange-traded funds (ETFs) on the SGX do include some indexes such as the S&P 500 and the STI. My recent thoughts on the STI can be found here: Does the Recent Drop in the STI Represent a Good Buying Oppourtunity?

What are so special about index funds? Well, they attempt to get the returns of the underlying index, such as the S&P 500 and the STI, but owning shares in the similar proportions that the index is made of. For example, as the STI is a market-cap weighted index, hence the weightage of each share in the index is dependent on the market cap of the shares. DBS, with the largest market cap in the STI, has the highest index weightage. There are also price-weighted indexes, where the price of each share determines the weightage of the share in the index.

The indexes that are tracked by the index funds usually are well-diversified with many constituent shares (the STI has 30 while the S&P 500 has 500). The STI in Singapore also has exposure to different industries in Singapore and hence for a relatively low investment sum (far less than it would take to invest in all of the constituent stocks), the individual investor can get access to a well-diversified stock portfolio of the Singapore market. To get better diversification, the ST All-Share Index is better in my opinion, but there are no ETFs tracking it.

Buying index funds is better than buying unit funds as the basket of shares that it owns in dependent on the index and not on the choices of the fund manager. Though there are good fund managers, there are many bad ones as well, while an index is usually the standard that fund managers compare their performance to, as it is supposedly the "average performance" of the market. So, they are meant to give an average return, which is actually not that bad, around 7% for the STI with dividends, of the market. So this reduces the risk of choices a bad fund manager when buying an index fund.

But the main key advantage of buying index funds is due to their (usually) low expense ratio. For example, the SPDR STI ETF has an expense ratio of around 0.30% of Net Asset Value of share. Considering that unit funds have management fees and high expense ratios due to their relatively frequent trading which racks up costs, These fees eat into the return of the investor and the manager would have to outperform the market by that percentage just to deliver the market return to the investor.

Since market indexes are designed to give a cross-section of the market, it would be designed to show the average return of all the investor and fund managers. Since this is the average, the chances of one picking a fund manager that will outperform the market is almost as good as the chances that you would pick one that would underperform it. Add in the expense ratios and the chances of any particular fund manager beating the market drops considerably.

It is best to diversify your own stock portfolio, by owning multiple index funds that provide of cross section of different countries (STI, S&P 500, Hang Seng), or even a global index fund. This gives exposure to different countries as well as different industries in each of those countries. This tactic is good especially for investors that do not want to spend a lot of time deciding which stocks to buy and would like to take less risk.

A quote to sum up this post: 
"Wide diversification is only required when investors do not understand what they are doing." 
- Warren Buffett

Another way some people like to diversify is by spreading out the time in which you buy your shares, through dollar-cost averaging, to ensure that you don't buy at peaks. My thoughts on dollar-cost averaging can be seen here: Thoughts on Dollar-Cost Averaging

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