The so-called passive funds occupy a special place in the financial market – they allow private depositors to earn, reducing costs. But at the same time, they noticeably slow down the development of the economy, narrowing the field for investments and cutting off growth prospects for little-known companies.
The eternal problem: how to make money and then keep it. Traditionally, most people keep their savings in deposit accounts. These are classic passive investments, providing a guaranteed income. Let it not be as high as we would like it to be.
In addition to banks, individuals invest in various financial structures like credit unions, buy bonds, and participate in a savings life insurance program. They invest quite willingly in index funds (Exchange Traded Funds – ETFs). This instrument is simplistically compared to betting on every horse in the race at the same time since it involves buying all assets available for investment in shares proportional to their market capitalization.
The main peculiarity of such funds is the maximum simplicity of the strategy with minimum expenses for management. That is why they are referred to as passive investments or investments for the lazy.
Only the careless don’t invest in ETFs
The first index fund was created in 1993 by State Street. After that, their popularity only grew. There are now about 2,000 such companies in the world. The total value of their assets is close to $11 trillion. About 80% of them are controlled by the universally recognized top three – State Street, Vanguard, and BlackRock. At the same time, ETFs control from 20% to 30% of all shares of the U.S. stock market.
Individuals are increasingly actively investing personal funds in such companies, expecting a higher return with less time than from a bank deposit. To illustrate: in 2016, savers withdrew about $300 billion from conventional funds and invested about $500 billion in index funds. At the end of 2019, the outperformance of the latter is palpable. People don’t want to spend time making the right choice: which securities to sell and which to buy. It’s much easier to buy ETF shares and live with a modest but steady return.
Simplicity and profitability
The mechanism of index funds is very similar to regular funds, which in most countries function according to time-tested methods. Individuals invest their money in securities, the good news is that it can now be done with the click of a smartphone. The asset management company invests the funds raised and earns income, which is distributed among the participants.
Such a fund has a number of distinguishing features that make it particularly convenient for private investors. All money is invested in securities, usually shares of a particular stock index.
The most popular passive fund in the world right now is the SPDR S&P 500 ETF, which invests capital only in assets that are part of the S&P 500. As a consequence, their value dynamics synchronously repeat changes in the index. It is easier for a private investor to track the latter index than the behavior of a large number of securities in circulation. Thus, the process is simplified for small investors who:
- do not have the necessary knowledge of the financial market;
- have neither the time nor the desire to search for, buy and sell securities.
As a rule, passive funds are closed-end funds, in other words, they pay dividends based on the growth of the stock index.
In addition, the company managing its assets usually takes less commission than a classic investment fund. In numerical terms, this balance tentatively looks like 0.1-0.2% to 2%. Everywhere you look – everything is in the interests of the private investor: low commissions, liquidity, transparency.
However, analysts observing the evolution of financial flows conclude that when lazy depositors prevail, capital will go to large companies that form the index. Only crumbs from the table will go to promising businesses, whose main drawback is low visibility.
Evil tongues say that passive investing is worse than Marxism. Indeed, such a position on the stock market, unwillingness to take risks eventually leads to monopolization of big capital and causes the growth of prices and decrease of salaries.
Wide field of possibilities
Very often index funds take as their basis the S&P 500 which is rightly called a barometer of the American economy. But successful ETFs also operate using other indexes, including industrial ones, as a reference point.
For example, the iShares MSCI Emerging Markets ETF works on emerging markets stock markets, the Financial Select Sector SPDR Fund invests in stocks of banks, insurance companies, and other financial sector representatives, the VanEck Vectors Gold Miners ETF deals with securities of gold mining companies.
Some, like the VelocityShares Daily 2x VIX Short Term ETN invest in futures, others, like the SPDR S&P Dividend, invest in stocks of companies that regularly pay dividends.
A wide range of models allows individuals to find the most attractive strategy. Because of the pandemic and restrictive measures, passive investors prefer those index funds that invest in pharmaceuticals and the IT sector.
To understand how much you can earn from passive funds, just look at their returns. Over three years, assets in the SPDR S&P 500 ETF have grown 40%, the iShares Core S&P 500 has grown 41%, and Invesco QQQ, which invests in NASDAQ stocks, has jumped 72% (131% over five years!).
Are index funds popular in Russia ?
In Russia, a year ago they accounted for slightly more than 1% of the net asset value (NAV), now it is 3.8%. The growth of interest is evident. Analysts explain it by the convenience of buying them not from an agent or management company, but on the stock exchange online at a known price. However, the efficiency of the Russian stock market is much lower than that of the American market.
This is all the more reasonable because there is a tax exemption. If an individual receives income from investment funds, he or she will have to pay 18% income tax plus a 1.5% military surcharge. If it is dividends from a passive fund, however, the tax is only 5%.
What more proof do you need of the potential of index funds?