Index Fund Investing

Why use index fund investing?

What is an Index?

An index is a group of companies that make up a specific market sector or asset class. One of the most well known indexes is the S&P 500. The S&P 500 is an index of the 500 largest public companies in the U.S.

What is an Index Fund?

A fund that is set up to track the performance of a specific index and provide exposure to the market returns (or losses) of all the different companies within that index. The fund is what you are actually purchasing shares of; the index is what you are trying to track. If you want exposure to the S&P 500 index, you might purchase shares of the VOO S&P 500 ETF. The goal of this fund is to match the returns of the S&P 500.

Construction of "The Color Block Index Fund"

An index fund is made up of shares of the companies in the index that the fund tracks. However, unlike the above example, exposure to each company is not always evenly weighted within the index. At One Day In July we predominantly use “Market Capitalization Weighted” index funds.

Market Capitalization

Market capitalization is the total value of all outstanding shares of a company. This value is constantly changing as share prices fluctuate throughout the day.

share price x number of outstanding shares = Market Capitalization

Market Capitalization Weighting

Market capitalization weighting is a type of index fund construction where the weightings of companies within the fund are based on the market capitalization of each company relative to the cumulative market capitalization of the entire index.

If “Company Z” has a market capitalization of $10B, and the index it is in has a cumulative market capitalization of $100B then shares of “Company Z” will make up 10% of the index fund that you purchase. Other companies in the index will make up the remaining 90% based on their market capitalizations.

When you purchase one share of an index fund, that share actually exposes you to shares of several companies. When you purchase one share of VOO S&P 500 ETF, a fund set up to track the S&P 500, that share is made up of exposure to the 500 largest public companies in the U.S., weighted based on the relative market capitalization of each company in the index compared to the cumulative market capitalization of the S&P 500 index.

This means that companies with larger market capitalizations within a given index will have a larger presence in that index fund than companies with smaller market capitalizations. As these market capitalizations shift over time their weightings in the index fund are adjusted accordingly.

Market Capitalization Weighting in the Construction of an Index Fund

Benefits of Index Fund Investing

When you purchase shares of an individual company you are exposed to only that company’s gains or losses. When you purchase shares of an index fund you are purchasing exposure to all of the companies in the index it tracks, all at once.

As an example, if you purchase shares of “The Light Blue Company,” a company within the “Color Block Index,” you will have either gains or losses based solely on how that company performs.

Purchase a Share of "The Light Blue Company"

“The Light Blue Company” is a part of “The Color Block Index Fund.” If it has a negative performance one year, you have the opportunity to make up that loss through the many other companies in the index.

Purchase a Share of "The Color Block Index Fund"

It is extraordinarily difficult to beat the overall market by selecting individual stocks. This example shows possible outcomes of investing $100 in “The Color Block Index Fund” versus “The Light Blue Company” (a company within “The Color Block Index”) over two years. When investing in the index fund you have exposure to all of the companies in the index. When investing in a single company you rely entirely on that one company’s performance to produce your gains - or losses.

Year 1 Performance of "The Color Block Index Fund"

But what if instead of investing $100 in “The Color Block Index Fund,” you decided to purchase $100 worth of individual shares of “The Light Blue Company,” a company within the index.

Year 1 Performance of "The Light Blue Company"

Before showing the fund’s Year 2 example performance, we need to show the adjusted Market Capitalization Weighting of the fund based on the performance we showed above in Year 1.

Adjusted Market Capitalization Weighting of "The Color Block Index Fund"

"Color Block Index Fund" Market Cap after Year 1: $158.0B
The Market Capitalization Weighting of the index is constantly adjusting based on the changing Market Capitalization of each company.

Year 2 Performance of "The Color Block Index Fund"

Year 2 Performance of "The Light Blue Company"

In year two, “The Light Blue Company” outperformed the index, but will it be able to replicate that result next year? Studies show that an individual stock is unlikely to outperform the index over any long period of time. In fact, based on Hendrick Bessembinder’s study, the overwhelming majority of individual stocks did not outperform a one month U.S. Treasury bond during the years between 1926 and 2016. In other words, many investors took on the risk of the stock market and achieved returns less than those achieved from what is generally considered to be a risk-free investment.

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