Hey friends! This is Neil and thanks for reading Neil$letter.
Last time, we looked at how to enter a trade at a digital brokerage, and the time before that, we talked about why you might want to open a Roth IRA account. If you’re new here, I strongly recommend checking out my first post, How to be a financial badass.
Today, we’re going to take a good look at the building blocks of modern investment portfolios, known as index funds. If you get to know these, it will help a lot with your financial offense - for Roth IRAs, as well as 401ks.
Before continuing, please review Neil$letter disclaimers and disclosures.
What is an index fund?
Don’t be mystified - an index fund is simply a financial product. It is a portfolio of companies whose performance is designed to track an underlying index. There are hundreds, if not thousands, of index fund products on the market today in the form of both mutual funds and exchange traded funds (ETFs).
The major US indices
There are three major US indexes you should know about:
The Dow Jones Industrial Average - this is a group of 30 companies that are some of the largest and most-established in the country. It’s sort of a historical index in my opinion - still widely reported on, but less relevant than the S&P 500.
The Standard and Poor’s (S&P) 500 - this popular index measures the 500 largest companies in the US. Investors often compare their returns to this exact index.
The Nasdaq - in addition to the New York Stock Exchange (NYSE), the Nasdaq composite is a stock exchange with over 2,500 stocks. There is also the Nasdaq 100, which follows the movements of the largest 100 non-financial companies in the Nasdaq composite. In my opinion, the Nasdaq has become the most important US index, with its emphasis on the massive US technology sector, and generally being a bit more forward-thinking.
There are also tons of international indices, and a ever-increasing array of niche indices (such as the S&P Global Clean Energy Index) - but to keep things simple, for now we’ll just look at some of the biggest and most popular.
Index fund history
Index funds are actually a relatively new invention. The early ideas for what would become the first index fund originated at the University of Chicago in the mid 20th century (1950s and 1960s), and were later popularized by John Bogle, founder of The Vanguard Group. By the mid 1970s, Bogle had launched The Vanguard 500 Index Fund mutual fund (ticker: VFINX). This was made to track the S&P 500, or as mentioned above, the performance of the 500 largest publicly traded companies in the United States.
In doing so, Bogle and Vanguard simplified investing, and helped to make it lower-cost (by reducing the need for management) and lower-risk (by adding easy diversification). From 1975 to 1999, indexing exploded - with Vanguard as, well, the vanguard of the index investing movement. The VFINX index went from $11 million in assets to over $100 billion in that time, as more companies offered 401ks, and those 401ks began to heavily feature index funds. Outside of the workplace, families turned to companies like Vanguard to help them invest in their taxable and retirement accounts, and big institutional money was a major driver, as well.
What’s in an index?
Once you start to get to know stocks well, you can take a glance at the top 10 holdings of a fund and learn quite a bit about it. Let’s do so for the DIA ETF (which tracks the Dow Jones Industrial Average), the SPY ETF (which tracks the S&P 500), and the QQQ ETF (which tracks the Nasdaq 100).
Here’s DIA. The “Fund Top Holdings” are on the left (ignore the “Shares Held” number), and the actual index is on the right. You can see how closely these names and numbers match (note the slight delay on the index holdings on the right):
What do you see? (If you’ve never looked at a stock list like this, it might be a bit bewildering. Just stick with it for a moment!) What I see is a fund that is concentrated into a lot of large cap, “blue chip” US names in a variety of sectors: healthcare, finance, retail, tech, biotech, and industrials.
Up next is SPY. Right away, we can start comparing and contrasting what’s in SPY versus what we saw above in DIA. We see quite a different list of companies, with big tech companies featuring more prominently. (Again, we’re ignoring the “Shares Held” column and just focusing on the allocation, or “Weight.” The fund matches the index perfectly with both being as of the same date.)
And last let’s look at QQQ. Here we see technology dominating the top 10 list, with quite high allocations to the top 5 companies.
Fund weighting & market capitalization
I’m not an index designer, so I can’t tell you the full magic behind how these indices derive how much weight each company gets, and who gets included. But generally, companies are weighted and included by their market capitalization, which is the total number of shares outstanding times the current share price. (Example: Apple Stock has almost 15.9 billion shares outstanding, and each share can be sold at the current market value of $164.32. Thus, Apple’s “market cap” is roughly $2.61 trillion dollars, making it the biggest company in the world.) So massive companies like Apple tend to get a much higher weighting, while tiny companies may get only a small fraction of one percent.
Another interesting strategy is to simply equal-weight the fund. This doesn’t generally apply to index funds, so I won’t spend much time on it, but in this strategy, if you had 100 companies, each company would get an equal 1% weighting, while 50 companies would get 2% each, etc. This has the effect of de-emphasizing the performance of large companies, and puts more emphasis on the smaller ones.
Zooming out: other index funds of note
I want to briefly highlight a few popular Vanguard index funds:
VTI - The Vanguard Total Stock Market ETF
VT - The Vanguard Total World Stock ETF
VXUS - The Vanguard Total International Stock ETF
Whenever you see “total stock market” type funds, you should think of funds that likely only encompass the entire US stock market. On the other hand, when you see “total world” or “all world” or “global” you should think of funds that have ownership broadly across the world, often still with a significant US component. And last, when you see “international stock” or “excluding US (/ex-US)” you should think of funds that solely own companies headquartered outside of the US.
I see VTI as an evolution of the likes of SPY, DIA, and QQQ. It holds well over 3,000 US-listed companies, so is much more broadly diversified. It also captures more small-cap companies, whereas the former tend to focus solely on large-cap. In my last post, we used VTI as a fractional share purchase example to show that you could put in even small amounts of money into an index.
VT is basically a 60/40 stock portfolio, holding roughly 60% US stocks, and 40% international stocks.
VXUS is purely international stocks, and can be used to compliment a portfolio of US stocks.
Diversity: top 10 concentration & total number of holdings
In the above sections, we’ve already started talking about diversification - the idea that “you don’t want to put all of your eggs in the same basket.” When considering how diversified a fund is, we want to look at how much of that fund is held in the top 10 holdings, as well how many total holdings it has.
For the DIA, there are only 30 companies in the Dow Jones Industrial Average Index, so it’s not that surprising that the top 10 companies make up a whopping 54.72% of the fund.
For SPY, we see that the top 10 makes up only 27.07% of the fund (which makes sense because it has another 490 holdings to match the 500 in the S&P 500).
For QQQ, which tracks the Nasdaq 100, we again see a more concentrated portfolio, with the top 10 being 55.08% of the fund.
For VT, on the other end of the spectrum, the top 10 make up only 14% of the fund. It holds small amounts of stock in nearly 10,000 companies around the world!
Assets under management (AUM)
Another useful number to look at is the fund’s total assets under management. How many dollars have other investors put in? This will tell you how popular the fund is (especially relative to funds with similar strategies), and perhaps something about the fund’s safety and liquidity. If you’re putting your dollars to work with billions of others, you’re probably in decent hands. If you’re interested in a newer fund with only a million? Stay cautious.
Expense ratio
You really want to watch your fees and expenses when investing. In the context of index investing, that means finding very low expense ratio funds, which luckily are very common today - I have been highlighting some of them in Vanguard’s ETFs. For an index fund, you want a 0% expense ratio ideally - you can find that in a few products, including some Fidelity-only mutual funds. Other examples of low expense ratios: 0.03%, 0.06%. Even if you held these over many decades, the expense wouldn’t materially eat into your returns.
Once you start moving to actively managed funds, it’s very possible to see 0.5% to 2% or more expense ratios. Remember when we talked about the importance of compound interest? It doesn’t seem like much, but a 1% or 2% drag on your annual returns (which is what expense ratios basically represent) can really add up over the years.
That’s not to say actively managed funds aren’t worthwhile, they can be. But they’re certainly more complex and more expensive than the good old default, which is a low-cost index fund.
My style
I like to be fairly concentrated in technology stocks historically, so my favorite index is QQQ. I’m more of a classic, active management, “try to beat the market but often fail” kind of guy, not an index investor. But honestly, I’d probably be happier, less stressed, and richer if I just indexed. For anyone starting out, indexing in a retirement account over many years is about as close to a no-brainer and to “free money” as investing gets, in my opinion.
The final word
As always, please consider all of this “food for thought” and not financial advice, as there is no “one size fits all” in personal finance.
I’ve thrown quite a bit of info out today! If you’re new to the world of finance, God bless you for reading this far. I’ll admit, it’s a little dry (even for me) - and I like to geek out on this stuff! Trust me that by eating your financial veggies now, you’ll be stronger for it later. You’ll become more fluent in understanding all the complexities of investing, and you’ll have some sense of how things interconnect and what works for you. By understanding a bit of the basics about index funds, you not only have a good foundation for your own Roth IRA, but also for investing in company 401ks, where index funds are usually some of the only things on offer. Additionally, if you choose to use robo advisors, target date funds, or even perhaps a professional advisor, you will be seeing a lot of index funds. Finally, all stock performance is relative - it is compared to a benchmark. That benchmark is usually an index.
If you’ve found this post useful, I would be delighted if you subscribed and shared it. Please also mash like and leave a comment. Thank you for reading! -Neil
PS. One fun thing I’ve been enjoying - certainly not for everyone - is the bizarre world of John Lurie in his HBO Max show Painting With John:
This article really helped me understand index funds and how to think of them, which is a huge step forward, since I felt overwhelmed and baffled, by much of this in the past!
Plus, I love the idea of eating my financial veggies to grow stronger!!