Chapter 2 Investment Funds

Index Mutual Funds

An Index fund is essentially portfolios of stocks that match a particular index such as the S&P 500 with the aim to match it’s average yearly return, which for the last 100 years is about ~10%–11% not adjusting for inflation. The index fund also matches the weighting of the index, at the time of writing Apple is about 6.4% of the whole S&P 500. Therefore around 6.4 percent of the index would be made up of Apple stock. S&P 500 for example is the 500 biggest companies in the USA which covers all sectors that make up the economy.

“A low-cost index fund is the most sensible equity investment for the great majority of investors” — Warren Buffet

Index funds are passively managed due to just matching the index, this means there isn’t a person actively looking at the fund decided to buy or sell stocks to try and beat the market. This has the advantage of very low fees, with Vanguard’s average index fee being . Which in long term investing can stack up to a lot of money. For example most vanguard Index funds charge around about 0.35% annually, where if an another fund charges around 1.4% annually then investing £300 per month for the next 30 years, and we assumed average over the 30 years was about 10% growth then the lower costing fund will yield an extra ~£106,384. So that’s an extra £100K for just using a cheaper fund this number compounds higher and higher the long the money is invested.

“Don’t look for the needle just buy the hay stack” — Jack Bogle

Buying a well diversified a index fund like the S&P 500 ensures that you are exposed to all markets across the whole section of the economy. So if Oil was to be suddenly banned then your stocks in BP Oil wouldn’t be worth much but shares in a good index fund would be well protected due to the diversification.

“Diversification is a protection against ignorance” — Warren Buffet

An index will provide good yearly returns over the long term for the average person that doesn’t know what they are doing. You may not want to constantly look at stocks and read annual reports. You can just buy and hold for the long term. You can further protect yourself from the market ups and down by buying shares in index fund monthly this is called dollar cost averaging or drip feeding. You don’t need to watch the price to see when the best to buy is. Because by dripping feeding you buy share when they are cheap and expensive, over the long term it averages out to a normalised price.

Summary: Drip feed cash into a low cost, well diversified index fund and over the long term you will do well. This is great for people who good returns with constantly checking the stock market. You just buy and hold over a long time and enjoy the wonders of comound interest.

“Compound interest is the eighth wonder of the world” — Albert Einstein

Dollar Cost Averaging

  • Dollar-cost averaging refers to the practice of dividing an investment of an equity up into multiple smaller investments of equal amounts, spaced out over regular intervals.
  • The goal of dollar-cost averaging is to reduce the overall impact of volatility on the price of the target asset; as the price will likely vary each time one of the periodic investments is made, the investment is not as highly subject to volatility.
  • Dollar-cost averaging aims to avoid making the mistake of making one lump-sum investment that is poorly timed with regard to asset pricing.

Exchange-Traded Funds

ETFs are more akin to stocks than to mutual funds. Listed on market exchanges just like individual stocks, they are highly liquid: They can be bought and sold like stock shares throughout the trading day, with prices fluctuating constantly. ETFs can track not just an index, but an industry, a commodity or even another fund. For example if you wanted to buy into Green Energy you could buy a Global Clean Energy ETF which would be made up of investment composed of global stocks in the clean energy sector.

Hedge Funds

Unlike Index funds and ETFs, Hedge funds are actively managed. With the intention that the person who is managing the fund can beat the average returns of the market. They have a lot more freedom to buy and sell stocks when they think it’s the best time. In theory they could buy the best performing stocks which would deliver higher returns, however there is no real way of knowing what these stocks are going to be. They are also only buying stocks which are available for the individual or passive index investor. So picking a hedge fund is really picking the best manage that you will think can beat the market.

Costs

Due to being actively managed there high fees for a hedge fund for example an average hedge fund costs which normally operate at something called the Two and Twenty which refers to the standard management fee of 2% of the value assets annually, while 20 means the incentive fee of 20% of profits above a certain threshold known as the hurdle rate. If the fund beats the market by a lot then these cost are worth it as your returns are much better than your returns would be from the average market. However, poor performance or similar performance to the average returns from the market will result in a at least a 2% annual management fee which is far higher than passively managed fund and therefore will yield less returns on your investment.

Warren Buffett’s Bet

In 2007, Warren Buffett bet a million dollars that the Vanguard admiral S&P 500 Index fund would out perform any hedge fund and challenged a hedge manager to prove him wrong. A manager took him up on the bet and lost with just an average return of 2.2% against buffet’s 7.1% for his chosen index fund. Hedge funds have a disadvantage by their high fees to make good returns you need to beat market by a very large margin. It should be noted that during down turn in the market hedge funds generally do better because they can move money around more quickly and are more flexible with their investments.

Summary

In general a low cost very diversified index fund is best for most people. EFT’s are great for people who want to invest in particular industries or sectors in a fairly diversified way, such as Oil or renewable energy. If however, you think you have found the next Michael Burry who was the hedge fund manage who predicted the financial crash in 2008 and hedge against the US housing market, which he made a lot of money from. Then maybe it’s worth a shot at investing into a hedge fund. Personally, I would just stick with a great fund for 90% of your investments and have 10% in high risk but high rewards investments such as individual stock that you think will perform very well or even more riskier speculative options like Bitcoin.

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Richard Price-Jones

Richard Price-Jones

Software Engineer, Interested Finance and Tech