Why are index funds a popular choice for today's portfolio investors?

Index funds started to form in the 1970s and over the past 50 years have gained continuous acceptance from investors worldwide. The main reason is that long-term returns tend to align with overall market movements, while management costs remain lower than other options. This article will explain what index funds are, the benefits of investing in these products, why investors choose them, and the limitations to consider.

Index Funds: The Basics of Passive Investing

(Index Fund) is a type of investment mechanism managed through Passive Management, which involves purchasing securities according to the components that make up a reference market index.

Investors can understand from the fund’s name which index it tracks:

• S&P 500: An index comprising 500 large-cap companies in the United States
• SET 50: An index of 50 large-cap listed companies on the Thai stock exchange
• NAS 100: A major technology index consisting of 100 companies listed on NASDAQ

If you decide to invest in an S&P 500 index fund, it means you are proportionally an owner of all 500 companies. Since the fund buys all securities according to the market index, the fund’s (NAV) (Net Asset Value) closely correlates with the reference index.

When the S&P 500 drops 5%, the fund’s value is likely to decrease by a similar amount—an analogy.

A historical example is The Vanguard 500 Index Fund, established in 1976 by John Bogle. In 2019, this fund generated a total return of 31.46%, while the S&P 500 index itself returned 31.49%, demonstrating precise tracking.

Benefits of Investing in Index Funds: Why They Are the Wisdom of Smart Investors

Cost Efficiency and Lower Expenses

Index funds have significantly lower management fee structures compared to Active Funds. Since they are passive, they do not require stock selection (Stock Selection Process), eliminating the need to hire analysts and support staff. The fund simply follows the reference index. Not engaging in Market Timing also reduces trading costs.

Higher Long-Term Returns

A study by the SPIVA Scorecard in December 2018 revealed startling data: 82% of active funds investing in US stocks underperformed the S&P 500 over five years. Lower expense ratios, when compounded over the long term, create a substantial advantage. This is one reason why most active funds fail to outperform the market over the long run.

Effective Diversification

Index funds carry lower risk compared to active funds when considering diversification. The S&P 500 fund invests in 500 stocks, meaning that if one company faces difficulties and underperforms, the overall portfolio impact is mitigated. This contrasts with active funds, which may have concentrated investments in a few stocks.

Simplicity and Investment Discipline

Warren Buffett, a true investment legend, has advised novice investors to choose index funds like the S&P 500 and hold them long-term. His philosophy is that active funds often yield lower returns than the market, with only a few funds capable of outperforming it. Coupled with low fees, investors should select index funds and stick with them over the long term.

Limitations of Investing in Index Funds to Be Aware Of

Cannot Pick Your Favorite Stocks

Since index funds must invest in all securities that comprise the index, you may find that the fund invests in companies you are not interested in.

Returns Will Only Track the Index, Not Beat the Market

In the best case, returns will match the reference index (minus a small fee), but there is no opportunity to achieve higher-than-market returns. Unlike active funds, which have the potential to generate outstanding returns, they also carry higher risks.

How to Invest in Index Funds: The Starting Path

Index funds are designed to be user-friendly for retail investors compared to selecting individual stocks or other investment products. However, you still need to research which index aligns with your investment goals.

For investors interested in the US stock market, popular options include:

• S&P 500: Covering large companies across various industries
• NAS 100: Focused on technology companies, differing from the diversification of S&P 500

For the Chinese market (Hong Kong), which has high economic growth, the Hong Kong 50 (Hang Seng China 50 Index) includes 50 large companies from the Hong Kong, Shanghai, and Shenzhen stock exchanges, such as Tencent, Ping An, China Construction Bank, and other major banks.

Once you select the reference index, the next step is to choose a fund that tracks that index. Most funds will have similar returns because they all invest in the same components. Factors causing differences include:

• Expense Ratio (Management Fee)
• Currency exchange management fees (if choosing in Thai Baht)
• Trading fees

To select the best fund, compare historical performance between the funds and the reference index to see which fund manages to deliver returns most closely aligned with the index.

Then, you can open a fund trading account with a broker or commercial bank (most offer this service). Consider:

• Which distributors offer the fund you are interested in
• Ease of account opening
• The fee structure offered

For investors familiar only with the Thai stock market, consider:

• SET Index Fund: Investing in all stocks on the Thai stock exchange
• SET 50 or SET 100 Index Fund: Focusing on the top 50 or 100 large companies
• Sector-specific funds: such as SET Banking Index Fund or SET Energy Index Fund, investing in banking or energy sectors

Summary

At this point, you should have a clear understanding that index funds are an efficient tool for long-term investing. The benefits of index funds, including why many investors choose them, as well as their limitations, are important to understand. The next step is to study specific products, compare fee rates, and start investing with a clear strategy.