The Humble Guide To Passive Investing – Episode 3 – How Index Trackers Work To Make You Rich
Previously on The Humble Guide To Passive Investing (Episode 1 – Passive Investing & Why You Should Care)…
…I introduced you to the irresistible Passive Investing Strategy. We also talked about why this is a no-brainer path for a new and growing investor.
In Episode 2 – (Index Fund Investing & The Simple Path To Wealth), the storytelling continued with an intro to index funds.
We also explored both the advantages and disadvantages of index fund investing. Plus we touched on how you actually invest in index funds and how to succeed at it.
Today, we dive into how exactly these index trackers work to make you rich.
Passive investing via trackers is meant to be easy and hassle-free for most people.
However, if you’re a newbie, it can appear daunting and somewhat complicated unnecessarily.
Most people drop off purely because of the lingo and others because they simply don’t know where to start.
This guide is there to act as your map and will cover as much of this path to investing as possible so that you can confidently do it yourself.
As mentioned in previous episodes of this guide, there are 2 main types of tracker funds:
1. Index Funds
This is the original and simpler of the two main types of trackers.
It’s is suitable for newbie and ongoing investors, especially if you do you investing via monthly direct debits.
These funds are mostly structured as companies called OEICs (Open Ended Investment Companies).
Essentially, it’s a UK term for a money pooled in a pot to be invested across various types of things like equities and the like.
Other index funds in the UK are structured as Unit Trusts.
In the US, these are referred to as mutual funds.
Both OEIC and Unit Trusts are “Open Ended”, which means that you can freely buy and sell shares in the fund.
Note that index funds don’t attract a trading or dealing cost. All you pay is an annual fee, usually zero point something (super cheap!).
2. Exchange Traded Funds (ETFs)
This is similar to an index fund, except it behaves like a share. I.e. you buy and sell it on the stock market.
As a result of this buying and selling on a stock market, you pay trading costs (~£10 or so per trade. We’ll over fees separately in this series.
Note that you don’t pay trading costs for index funds mentioned above as you aren’t trading them on a stock exchange.
ETFs are the new kids on the block and offer us, investors, a ton more choice!
To give you an idea, there are around 1,500 listed ETFs on the UK Stock Exchange. This will continue to grow for the foreseeable due to popularity.
An ETF is simply a way to invest in the entire market (or an index) through buying a unit that behaves like a company share.
As it’s a tracker, you can buy an ETF tracking pretty much anything index (i.e. lists). Examples include ETFs tracking the FTSE 100 or the S&P 500.
You can even buy ETFs tracking commodities like gold, cocoa etc.
ETFs have unique advantages worth sharing:
They offer you liquidity as you can trade them easily like a share. As such, you can get your cash back super quickly.
You get transparency about the price you are paying including any trading costs.
You have diversification with investments spread across various securities such as equities, bonds, property etc.
It’s super low cost. As it’s passive and not actively managed, you aren’t paying for the expertise of a manager.
Let’s Talk Jargon
As previously mentioned, jargon is one of the reasons many get put off even starting investing.
Say you want to buy the ETF that tracks an index, what do you search for and where?
We will get to platforms later in this series. For now, let’s tackle the ‘what you search for' bit.
All funds have a unique ISIN (International Securities Identification Number) for identifying them. It’s 12 digits and alphanumeric.
Below are random examples (for illustration only, not recommendations!) of Funds:
A) Vanguard FTSE 100 UCITS ETF (ISIN: IE00B810Q511)
B) iShares FTSE 100 UCITS ETF (Dist) (ISIN: IE0005042456)
C) Vanguard S&P 500 ETF UCITS (ISIN: IE00B3XXRP09)
Let’s dive into what these various components in each fund name actually mean.
Pick (A) above: Vanguard FTSE 100 UCITS ETF (ISIN: IE00B810Q511)
“Vanguard” is the name of the fund provider.
“FTSE100” is the index (i.e. a list) that this fund is tracking or copying.
“UCITS” stands for Undertakings for Collective Investments In Transferable Securities. It’s essentially a badge of approval from the European regulator.
“ETF” is Exchange Traded Fund as covered above
Pick (B) above: iShares FTSE 100 UCITS ETF (Dist) (ISIN: IE0005042456)
Notice the “Dist” in brackets at the end of the name? This stands for “Distribution” and essentially means that you get dividends distributed to you.
Essentially, this particular ETF will pay dividends (typically quarterly, and you will receive it periodically.
What you want to ensure though is that you reinvest these dividends so that they can work for you. This is really the big point about investing and compounding interest.
The Index Being Tracked
The index is a sample of the market or a segment of the stock market.
It’s in effect a list of stocks, although the list you track matters for reasons covered below.
This list is usually put together by a committee based on some criteria for which companies to include.
Examples of some of the most famous indexes include the FTSE100 and the S&P500.
These are very popular partly because of the reputation of the companies that have compiled the list.
The FTSE100 (list of the top 100 companies in the UK) is owned by FTSE Group.
Whereas the S&P500 in the US is owned by S&P Dow Jones Indexes. Both very reputable companies.
How Index Trackers Work To Make You Rich
Index trackers essentially help many investors come together and invest in a pool (pot of money).
That pool is then used (via a tracker) to buy bits of every company in an index.
Some trackers fully replicate the holdings in the index, whilst some do it partially.
As an example of full replication – a FTSE 100 Index Tracker would also mirror and invest in all 100 companies.
Note that the tracker is not focused on picking winning stocks. As such, it is not timing the market!
This is a very important assumption re passive investing as a strategy.
The tracker simply focuses on its primary job of tracking the index and earning the returns from the related securities.
It's through this pooling that you and I can in effect have holdings in potentially hundreds of companies globally.
Doing this on your own individually would prove to be expensive and impractical.
The broader the base of the index being tracked, the better.
So your FTSE 100, FTSE All-Share, S&P 500 are the types to focus on.
These give as much diversification as possible and remove specific risk tied to individual companies.
This gets even better if the index being tracked has companies with operations not just tied to one country for example.
This way you're also diversifying away specific risks tied to individual nations.
Such global trackers are now available and cheaply too. The key is to invest as broadly as possible.
Before you can decide which tracker you want to pick, you'll first need to think about:
A) What market are you interested in tracking? For example, it could be the UK Equity or US Equity etc.
B) Which indexes (i.e. lists) track or cover that market?
Using UK equity as an example, the notable indexes that cover this market are the FTSE100 and FTSE All-Share.
Both these cover this market to different extents.
FTSE 100 Index covers the top 100 largest UK companies listed on the London Stock Exchange.
FTSE All-Share Index covers 98 – 99% of the UK Market Cap. It is made up of the FTSE 100, FTSE 250 and FTSE Small Cap Indexes.
As we covered earlier, the broader the index fund, the better.
As such, once that tracks the FTSE All-Share Index would offer the most diversification.
This shouldn’t ofcourse stop you tracking the FTSE 100 instead if you don’t want exposure to smaller companies.
The “fact sheet” of every fund you search for will detail the exact index the tracker is following.
Please visit their sites for more information.
I hope you've found that useful. Over the next few episodes in this series, we'll cover platforms, etc.
- Episode 1 – Passive Investing and Why You Should Care
- Episode 2 – Index Fund Investing and The Simple Path To Wealth
- Investing Risks You Should Be Aware Of
- 30+ Life Changing Books – Investing, Business, etc
Additional investing resource:
Are you currently an Index Fund Or ETF investor? If so, any challenges? Or Are you completely new? Do share any concerns you have below.
Do please share this post if you found it useful, and remember, in all things be thankful and Seek Joy.