9. How to select an index fund

As previously discussed, the books suggest that most people should invest in an index fund. But how do you choose one? What are the most impactful variables when selecting or creating such an instrument, what should the retail investor look out for? Here we go through what the books consider the most important qualities for a broad market index instrument.

What is an index fund?

An index fund is a fund set up to mirror an index like the S&P 500. The goal is to mirror the index as effectively as possible whilst keeping the costs low. The low cost is an important variable for an index fund, as that is one of the key items which makes the performance of an index fund so good over time. You can read more about it here.

What then are the main variables that set indexes apart?

• The method of selecting securities — which does it contain?
• The balancing (and rebalancing) method — how much of each security?
• Amount of securities included in the index

It is impossible to label any choice right or wrong (except perhaps those that result in a a crushing fee). It is important that you make sure that the funds that you select are, and behave, as you expect.

Different indexes

An index can have many different strategies. From the one which tries to mirror an entire market to one with an equal distribution. There are those who are focusing on securities in emerging markets, on securities with high growth potential, on securities with low valuation and securities with high revenues instead of market capitalisation. The thoughts behind this is to beat the average by trying to identify a group of securities that will outpace the market. Malkiel spends Chapter 11 discussing these and presents his view in the intro of the chapter.

This chapter explains what “smart beta” us, what kinds of funds pursue this strategy, and why so many people are excited about it. It shows why “smart beta” flunks a safety test, and why it is not as smart as it claims to be. The chapter concludes that a “smart beta” is not a way to go for the individual investor, and it argues that the tried-and-true approach — investing in low cost, broad based capitalisation-weighted index funds — ist still the best way to build an investment portfolio. (Malkiel, p. 261)

Emphasising small stocks over large, or value stocks over growth, or consumer goods over capital goods, are all tactical moves that a funds portfolio manager might make in the search to improve returns relative to the overall market. I expressed skepticism that most managers will be able to enhance returns through these tactical moves [..] The record is clear that, for professional investment managers as a group, these kinds of tactics are unproductive. (Bogle, p.246)

Ideally, you want an index fund that tracks the whole market (Graham, p. 347)

As crypto currency is very risky in itself, it is suggested that one choses the most conservative route, a broad market cap weighted fund, and elects to try and find an index which mirrors the whole market. This blog entry will focus on choices that enable you to mirror the whole market.

If your goal is to own the whole market, then in the stock market you are aiming for an index that
1) Chooses companies based on market capitalisation
2) Want to balance their portfolio proportionally to their market capitalization
3) Includes as many companies as possible

Selection process

There are many ways in which one can select securities. S&P 500 contains the 500 biggest companies based on market capitalisation and represents about 70% of the US stock market. Russel 3000 is an index that tracks the 3000 largest U.S. companies based on total market capitalisation and represents 98% of the market. OMSX30 tracks the top 30 public companies on the Swedish stock market based on revenue.

If your goal is to own the whole market, then the choice here is clear. Pick an instrument which selects the biggest crypto currencies based on market capitalization and includes as big a number as possible of them.

Balancing

The index can also balance the securities in different ways. For example:

• Equal distribution, where each security have the same amount of money invested in them.
• They could be weighted to market capitalisation, revenues, growth, PE, or other variables.
• Another possibility is to cap each individual security to some maximum size so that any security does not go above a certain factor of the portfolio.

If one wants to own the market as the authors in the books suggest one should go after a broad market cap weighted index. I.e., weigh the securities after how big their market capitalisation is. This means that bitcoin should make up about 41% of the portfolio right now.

Rebalancing frequency

Financial scholars who have been studying mutual fund performance for the last half century are unanimous upon a few points (Graham, p.243)
[…]
2) The higher a funds expenses, the lower its return.
3) The more frequently fund trades its stocks, the less it tends to earn.

Rebalancing means that you “recalculate” the optimal current portfolio allocation and performs trades that take you from your current portfolio to your target portfolio. This happens on predetermined frequency, for example once every quarter.

Rebalancing, i.e. selling and buying, leads to increased costs. Not all costs can be historically tested. The invisible cost, for example, is the difference between the calculated price and the actual price that you get after interacting on the market. (Bogle, p. 197). Increased costs leads to lower return for you, the customer.

If you want to own the whole market you should choose a market cap weighted index. It will require minimal rebalancing as its securities will grow and shrink in your portfolio as their market price changes. It requires rebalancing only when securities enter and exit the list.

To sum up rebalancing: One rebalances the fund to once again match the index. Depending on index and balancing frequency the costs will be impacted. Make sure that the funds argue well for why it has made its choice.

Amount of securities in an index

The choice of amount of securities included in the fund less discrete as there is a trade-off for costs and fees the lower down you go in size of the security. If you want to own the market, more securities enables you to own bigger portions of the market. The less popular a security is, however, the more it will cost to trade it.

Based on Markowitzs’ portfolio theory, 30 securities diversifies away most of the unsystematic risk. At 40 there is negligible gains due to diversification, and it plateaus at 60 (Malkiel, p. 212 + p. 201). As of 24/6/2018, the top 30 coins represent 90% of the entire market.

A selection of at least 30 securities in an index seems advisable. More securities is generally better, but be aware of how big the costs are for trading more securities! These costs should be clearly defined in any fund prospectus you read.

Fund fees

Cryptocurrency is an immature space with less efficiency than its developed big brother (stock and mutual funds). That the fees will be higher seems rational. What is a good fee, too expensive, and too little, is hard to predict. We offer three general guiding points. If curious, one can look into (Bogle, p. 197) of Bogle On Mutual Funds.

1. The fees and costs should be less than the increased returns. I.e., you get more value out than you put in.
2. The fees should be clearly documented in the annual fund report.
3. The fees should be reasonable.

All other things equal, the cost is important.

After all is said and done, higher costs always entail relatively lower returns in money market funds and generally do so in bond funds. For stock funds, there is simply no credible evidence that paying higher costs results in receiving higher returns. (Bogle, p. 208)

How to evaluate a fund

Bogle spends a chapter going through how to evaluate a fund prospectus and its annual reports which he considers containing valuable information. Every fund should have a fund prospectus and annual report in order to clearly communicate to the customer what they can expect if they become a customer of the fund. While the crypto industry is new and companies are younger than their institutional counterparts, we argue that any professional fund can only gain from these properties and that crypto funds should be evaluated with these points in mind.

Bogle have dedicated many pages for how to evaluate a fund, and starts at p. 149 in Bogle On Mutual Funds. The different topics that are relevant to the current discussion are..

1. Investment objectives. How does the fund seek to increase in value? Is this the same strategy that you are seeking? Expect clear statements of strategy (growth, value, current income, or others).
2. Fund investment policies, which (at best), describe what type of securities the fund will hold. For example, “stocks with above average yields and below average price-earnings ratios”. Or, “long-term bonds rated BBB or above”. Specificity is better than generalisation to minimise prospective investors confusion.
3. Risks. This is usually handled in a very general case. Capital risk and income risk should be described. In addition, the expected risk should be compared to the general risk in a fully diversified portfolio (like the S&P 500). Beta is often not included, but their disclosure would do more good than harm and relive the investor of the burden of finding it out.
4. Costs. Every investor should examine the cost table with care. The key item is in the total expenses incurred by the investor if the fund is held for a number of years and then sold.
   — The greatest cost variable is the sales load, i.e. the “entry fee”. These fees will invariably be the biggest fee if held for only one year, but becomes less the longer you hold the fund. A 5% entry fee would make up $50 of a $1000 investment if held only for one year, but roughly $5 per year if held for ten years.
5. An evaluation of the funds performance during the last time period, including an explanation of the major factors that contributed to the relative superiority or inferiority of the funds return. Benchmark comparisons to competitors and the market average.
6. Special items — does the fund depart from the norm in any way? Using other financial instruments, shorting, derivatives, etc.
7. Summary — The best prospectuses provide straightforward information on the funds suitability for particular investors and the role it is designed to play in an investors portfolio. It highlights the most important information and are written in sensible, easy to understand, english. Many write the first in a smattering of “legalese” and nearly all fail in the last.

Summary

Aim for a broad based, market cap weighted, index fund that mirrors as much as possible of the market. Demand that it should be reasonable and fair, almost like an uncle that you inherently trust. Demand that it should be transparent.

You now know what an index fund is and it’s different alternatives. We specified what you should look for if you want to own the market and finished of with info on how Bogle suggests you to evaluate stock and bond funds. Recap the info once more with a short summary.