Misunderstood index investing

2021-06-11 at 10:18 Timo Löyttyniemi

Index investing is often misunderstood. People say it’s easy. You just pick an index fund to invest in. Right, but before reaching this point you need to make a number of choices. Fact is that index investing is a much broader concept than people often think.

When investing in indexes, you select a single product to invest in a wide market. Often such a product is an index fund or, increasingly, an exchange traded fund (ETF). The former can typically be bought and sold in the same day or the next and the latter can be put up for sale on the market instantly. However, this simple choice has been preceded by a long chain of decisions.

What is a market portfolio?

When investing in indexes, you invest in the market. The first decision that needs to be made is to determine the market portfolio. Decades ago, the financial theory took a leap forward. One of its proponents claimed that the market portfolio contains all investment assets weighted at market value. Well, this is a daunting task. To do so, it is necessary to assess real estate property, land areas, stocks and fixed-income products and their market value weightings. The first simplification made here is selection of the stock market as an example of the entire market.

Markets are the world

The stock market index is a world stock index. Typically, this global index is the MSCI ACWI (All Countries Weighted Index). When you choose to invest according to this index, you invest 58% in the US market. Hence, the index investor is compelled to accept this high weighting on a single market. Moreover, index investors tend to forget that in many countries, there are a lot of companies outside the stock market. For instance, German companies appear to be under-represented in said index. Mid-cap German companies are often family-run businesses, but one may think that listed companies represent these companies. Consequently, it could be advisable to invest in Germany more than suggested by the index weighting.

What about other asset classes?

A simplified world index is a stock market index. It does not include fixed-income investments, private equity or infrastructure funds. While there is a world index for fixed-income funds, it only includes exchange-listed fixed income investments. The idea is simply to choose the universe which is investable.

For real estate investors, there is really no index-linked product. For example, in Europe the return index of non-listed real estate investment funds is based on funds worth EUR 300 billion. However, the total stock of funds available for investments in Europe is EUR 7000 billion. While the above return index gives the rate of return, you cannot make investment decisions based on the index. No index fund exists. It is necessary to make an active choice.

Private equity and infrastructure funds are examples of active choices. No index-linked investment products are available for them. They need to be selected and this selection is an active decision. Moreover, investments in real estate, private equity and infrastructure funds involve sets of contracts and all opportunities are not available. Hence, making investments in this way is a long process which calls for great expertise.

Investing in indexes is an active choice

When investing in a European stock market index, you must have made numerous choices, whether you are aware of it or not. Which index, which fund, euro-denominated or not, within the euro area or the whole of Europe? And once you have reached this point, you have already decided that a certain percentage is invested in stocks.

If the amount of capital varies and you decide to invest more in the market, you need to decide when to make the investment. All at once or gradually? When VER started investing in stocks in 2001, stock prices were falling. At that time, a decision was taken to make the equity investments gradually over a period of four years. It proved to be a sound decision. Usually time allocation pays off.

Asset weightings are not derived from the index

The most important decision an investor is called upon to make is the relative weighting of asset classes. He or she must decide how much to invest in equity market, fixed-income instruments, real estate and other illiquid assets. In this, the index offers little help. There is no index to tell you how much money or how much of an institution’s investment funds should be placed in the stock markets. The choice must be made by the investor him- or herself. If the choice is made by somebody else on behalf of the investor, a lot of questions need to be asked at that point. It is the only way to find out the expected returns and risks tolerance by the investor. Choice of ESG factors is making index investing even more demanding as investor put or are required to put some asset owner preferred weight for the ESG dimension. For a private individual, probably the biggest allocation decision is one’s home and mortgage. It is really far removed from index-linked investments.

In conclusion

If reduced to its bare bones, index investing is simple. If you wish to invest in a limited part of stock market, a tool for investing in an index is available and is often a good choice. Index-linked investing is a highly operative tool for targeted decision-making. All the decisions surrounding it may easily be overlooked. But it is these other decisions that are the most important ones for any investor.

The writer is VER's CEO Timo Löyttyniemi.

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