Index funds have been recommended on LW before. I have a hard time understanding how it would work investing in one, though. Do you actually own the separate stocks on the index of the index fund, or do you technically own something else? Where does the dividend money go?
(I’d be remiss if I didn’t link this Mr. Money Mustache post on index funds that explains why they are a good idea)
To buy an index fund, you buy shares of a mutual fund. That mutual fund invests in every stock in the chosen index, balanced based on whatever criteria they choose. Each share of the mutual fund is worth a portion of the underlying investment. At no point do you own separate stocks—you own shares of the fund, instead.
Toy example: You have an index fund that invests in every stock listed on the New York Stock Exchange. The fund invests in $1,000,000 of stock split evenly among every stock on the NYSE, then issues a thousand shares of the fund itself. You buy one share. Your share is worth $1,000. You can sell your shares back to the fund and they will give you $1,000. Over the next year, some stocks go up and some stocks go down. The fund doesn’t buy any more stock or sell any more shares. On average, the nominal value of the NYSE will go up by about 7%. The fund now owns $1,070,000 of stocks. Your one share is now worth $1,070.
The dividends go wherever you want them to. The one share of a thousand you bought above entitles you to 1/1000 of the dividends for the underlying stocks in the fund’s entire investment. If you’re smart, they go to buy more shares of the fund because compound interest will make you rich. You can have them disbursed to you as money you can exchange for good and services, though.
Investing in an index fund is very easy. You will pay by direct withdrawal from a bank account, so you will have to do something to confirm you own the account, but other than that it’s like buying anything else online.
Index funds cover costs—which are low, because buying more stock and re-balancing existing stock can be done by a not-that-sophisticated computer program—by charging you a small percentage of your investment. This is reflected by your shares (and dividends) not being worth quite 100% of the fund’s value. Index funds are good because they have a very low expense ratio. Many normal mutual funds charge upwards of 1% annually. A good index fund can charge about 0.20%-0.05%. That means you pay your fund about $20 for the privilege of making you about $700, every year.
Opinion time: I own shares in index funds. They are amazing. For a few hours work setting up an automatic transfer and filling out paperwork, I am slowly getting rich. I don’t need the money any time this decade, so even if the market crashes tomorrow in a 2008-level event, overall the occasional 1990s-style rises cancel that out, leaving real growth at about 5% assuming you use any dividends to purchase more shares.
I will let you skip the next part of this process and recommend a specific fund: The Vanguard Total Stock Market Index, VTSMX. It invests in every stock listed on the NYSE and NASDAQ. If you have $10k invested in it, the expense ratio is a super-low 0.05, and American stocks are very broad and exposed to world conditions as a whole (this is good—you want to spread out your portfolio as much as possible to reduce risk). Go to vanguard.com , you can figure it out online.
I think I could talk about the minutiae of investing all day. It’s fascinating. I should write that post about investing and the Singularity one day.
How would you estimate the probability that the post-Singularity world would consider pre-Singularity property to be too silly to be worth bothering with?
The most likely outcome is that pre-singularity property rights would indeed be meaningless post-singularity because (1) we are all dead, (2) wealth is distributed independent of pre-singularity rights, (3) scarcity has been abolished (meaning we have found a way of creating new free energy), or (4) the world is weird.
The Fermi paradox causes me to give higher weight to (1), (3) and (4).
Shouldn’t outcome 2 be given higher weight on account of having actually happened before? Reallocation of wealth seems to be a pretty common outcome of shifts in power.
Another investing question: if I already have some stocks that were given to me as a gift, am I better off selling them and putting the funds in an index, or just holding them?
Additional info: I already have a well funded index fund and a retirement account, the stock value would be around 10% of their (combined) value. I’ve owned the stocks for 10+ years.
As Lumifer said, if you sell stocks (and they’re up) you pay taxes on the capital gains—the difference between the price of the stock when you bought it and the price now. If the price now is lower, you get a tax credit for the losses, up to a certain point. Capital gains taxes tend to be lower than regular taxes (in America, at least). Selling shares of an index fund works the same way, where you pay taxes only on the gains, so selling stock to buy what is essentially more stock is pretty much a wash—you don’t pay more taxes overall, you just pay them now instead of later. I’m not sure whether being a gift affects the taxes, or what your basis is for capital gains. Investopedia might know, or ask an accountant.
Pretty much the choice of whether to sell the stock and buy more shares of the index fund is like any other choice in investment: which will make you more money? To simplify the math, imagine you sold all the shares now and paid taxes, so you had $X and could invest that in stocks or an index fund. Keep in mind the status quo bias—it is unlikely you would invest in this specific stock if you had $X to invest, and you should only keep the stock if that were the case (tax issues exempted—you’ll have to do the math yourself).
This is basically a tax issue. Selling the stocks would be a tax event so you need to calculate whether paying taxes now (instead of later) will be worth it.
There are two typical ways to invest in an index fund, plus one way that isn’t.
Buy a mutual fund that mimics the index you want to buy. You technically own shares in the mutual fund, which is an undivided right to a tiny percent of the whole pool. To get your money out, you have to redeem your shares, which happens at the fair market value. (It used to be that redemptions happened at fair market value at market closing price; I don’t know if that is still true.) To fund redemptions, the fund has to keep some cash on hand, so some small percent of your money isn’t actually invested. If you invest in mutual funds in a taxable account, the churn in fund holders’ redemptions create trades that cause capital gains, which creates taxable income for the fund as a whole. It will be a small percent, but it will still be there (on top of taxation of any dividends). This is because the legal model applied to your investment is like you are a partner in a partnership, where you get an allocation of profits and losses that are separate from your receipt of cash.
Buy an exchange traded fund that mimics the index you want to buy. These are still mutual funds in operation. The main difference here is that the shares in the fund are themselves tradable. Theoretically, I think this means that the fund does not have to redeem as much, so it can hold much less cash. It would do redemptions if people were bailing out of the market generally, so that sellers outnumber buyers. But the issuer can essentially make money by arbitraging any difference, which means effectively redemptions pay for themselves. Being exchange traded means that the mutual funds have to make some additional SEC filings, but these have become routine once EFT’s became popular, and the costs are spread over a truly vast number of people. The other main difference is that you only pay taxes on capital gains when you sell your ETF shares. That is because the legal model treats an ETF like an investment in a corporation, where the corporation’s profits and losses are not attributed to you, and you only get something when you get cash.
You can also buy all the shares yourself, which is something called a “synthetic” fund sometimes in rarefied circles. It eliminates all of the potential capital gains taxes until you sell the underlying assets, but it means that you have to buy a set of shares that would be really expensive and only comes in oddly sized chunks. For example, if you want to buy the stocks in the Dow Jones, that is 30 different stocks, any you would have to buy one of each. That might cost you $1,531.72. Who wants to buy investments at a price of $1,531.72 per unit? What do you do if you have $1,500 or $1,600?That is why ETF’s are so attractive. They get all of the convenience of the mutual fund, the capital gains tax treatment of owning shares directly. Index funds, whether regular mutual funds or exchange traded funds, also have the benefit of spreading fixed costs over huge numbers of people, so the expenses are usually very low.
Exchange traded funds are actually a little more clever than that. From the fund’s perspective, it doesn’t redeem fund shares for cash. The ETF has a number of “authorized participants” which are banks that can create new shares of the ETF. To create new shares of the ETF, they purchase the underlying shares in large quantities (called a “creation unit”) and provide them to the ETF, which then gives back the authorized participant the matching number of ETF shares. So for an S&P 500 ETF, the bank would first purchase all of the underlying shares of the S&P500 in the right quantity (generally a very large quantity) and provide them to the ETF, and the ETF would hand them X number of ETF shares that the bank can now sell. The banks make money through arbitrage, by buying and selling creation units when they are out of alignment with the price of the ETF.
A synthetic fund is slightly different from your description. A synthetic index is when you use derivatives to replicate the performance of an index fund. So rather than taking your $100 million charitable endowment and invest it in an index, you take your $100 million dollars and invest it in treasury securities, then enter into a swap contract that will replicate the perfomance of the index. Future payments go into your fund, and future shortfalls are removed from your fund. It can also be done with futures and the like.
It is very applicable to the UK. sixes_and_sevens document is a good start, but note that there is a whole world of online platforms now (Hargreaves Lansdown, Bestinvest, etc) which can be much more convenient and give you more control.
Note that there is SDRT of 0.5% on UK equities, which you will likely pay as a secret hidden tax on your index fund—the more ethical companies, such as Vanguard, make this clear—so you may wish to choose your index fund to avoid this pernicious tax. If you work in the UK, you are probably implicitly overexposed to the UK economy anyway, so this is an argument to track a global, non-UK stock index.
Most of the information on index funds that has been provided in this thread, and in links from this thread, is applicable to the UK. I suspect all the information you’re likely to retain, and need, is applicable.
Here is a quick-and-dirty document I threw together for London LWers looking to invest in index funds but not knowing where to start. There are better guides out there but they are necessarily longer. Googling “UK index tracker” will get you quite far.
Index funds have been recommended on LW before. I have a hard time understanding how it would work investing in one, though. Do you actually own the separate stocks on the index of the index fund, or do you technically own something else? Where does the dividend money go?
(I’d be remiss if I didn’t link this Mr. Money Mustache post on index funds that explains why they are a good idea)
To buy an index fund, you buy shares of a mutual fund. That mutual fund invests in every stock in the chosen index, balanced based on whatever criteria they choose. Each share of the mutual fund is worth a portion of the underlying investment. At no point do you own separate stocks—you own shares of the fund, instead.
Toy example: You have an index fund that invests in every stock listed on the New York Stock Exchange. The fund invests in $1,000,000 of stock split evenly among every stock on the NYSE, then issues a thousand shares of the fund itself. You buy one share. Your share is worth $1,000. You can sell your shares back to the fund and they will give you $1,000. Over the next year, some stocks go up and some stocks go down. The fund doesn’t buy any more stock or sell any more shares. On average, the nominal value of the NYSE will go up by about 7%. The fund now owns $1,070,000 of stocks. Your one share is now worth $1,070.
The dividends go wherever you want them to. The one share of a thousand you bought above entitles you to 1/1000 of the dividends for the underlying stocks in the fund’s entire investment. If you’re smart, they go to buy more shares of the fund because compound interest will make you rich. You can have them disbursed to you as money you can exchange for good and services, though.
Investing in an index fund is very easy. You will pay by direct withdrawal from a bank account, so you will have to do something to confirm you own the account, but other than that it’s like buying anything else online.
Index funds cover costs—which are low, because buying more stock and re-balancing existing stock can be done by a not-that-sophisticated computer program—by charging you a small percentage of your investment. This is reflected by your shares (and dividends) not being worth quite 100% of the fund’s value. Index funds are good because they have a very low expense ratio. Many normal mutual funds charge upwards of 1% annually. A good index fund can charge about 0.20%-0.05%. That means you pay your fund about $20 for the privilege of making you about $700, every year.
Opinion time: I own shares in index funds. They are amazing. For a few hours work setting up an automatic transfer and filling out paperwork, I am slowly getting rich. I don’t need the money any time this decade, so even if the market crashes tomorrow in a 2008-level event, overall the occasional 1990s-style rises cancel that out, leaving real growth at about 5% assuming you use any dividends to purchase more shares.
I will let you skip the next part of this process and recommend a specific fund: The Vanguard Total Stock Market Index, VTSMX. It invests in every stock listed on the NYSE and NASDAQ. If you have $10k invested in it, the expense ratio is a super-low 0.05, and American stocks are very broad and exposed to world conditions as a whole (this is good—you want to spread out your portfolio as much as possible to reduce risk). Go to vanguard.com , you can figure it out online.
I think I could talk about the minutiae of investing all day. It’s fascinating. I should write that post about investing and the Singularity one day.
The key is predicting what will happen to interest rates.
How would you estimate the probability that the post-Singularity world would consider pre-Singularity property to be too silly to be worth bothering with?
The most likely outcome is that pre-singularity property rights would indeed be meaningless post-singularity because (1) we are all dead, (2) wealth is distributed independent of pre-singularity rights, (3) scarcity has been abolished (meaning we have found a way of creating new free energy), or (4) the world is weird.
The Fermi paradox causes me to give higher weight to (1), (3) and (4).
Shouldn’t outcome 2 be given higher weight on account of having actually happened before? Reallocation of wealth seems to be a pretty common outcome of shifts in power.
Yes
Another investing question: if I already have some stocks that were given to me as a gift, am I better off selling them and putting the funds in an index, or just holding them?
Additional info: I already have a well funded index fund and a retirement account, the stock value would be around 10% of their (combined) value. I’ve owned the stocks for 10+ years.
As Lumifer said, if you sell stocks (and they’re up) you pay taxes on the capital gains—the difference between the price of the stock when you bought it and the price now. If the price now is lower, you get a tax credit for the losses, up to a certain point. Capital gains taxes tend to be lower than regular taxes (in America, at least). Selling shares of an index fund works the same way, where you pay taxes only on the gains, so selling stock to buy what is essentially more stock is pretty much a wash—you don’t pay more taxes overall, you just pay them now instead of later. I’m not sure whether being a gift affects the taxes, or what your basis is for capital gains. Investopedia might know, or ask an accountant.
Pretty much the choice of whether to sell the stock and buy more shares of the index fund is like any other choice in investment: which will make you more money? To simplify the math, imagine you sold all the shares now and paid taxes, so you had $X and could invest that in stocks or an index fund. Keep in mind the status quo bias—it is unlikely you would invest in this specific stock if you had $X to invest, and you should only keep the stock if that were the case (tax issues exempted—you’ll have to do the math yourself).
This is basically a tax issue. Selling the stocks would be a tax event so you need to calculate whether paying taxes now (instead of later) will be worth it.
Thanks for the detailed response. The link was very good, too.
There are two typical ways to invest in an index fund, plus one way that isn’t.
Buy a mutual fund that mimics the index you want to buy. You technically own shares in the mutual fund, which is an undivided right to a tiny percent of the whole pool. To get your money out, you have to redeem your shares, which happens at the fair market value. (It used to be that redemptions happened at fair market value at market closing price; I don’t know if that is still true.) To fund redemptions, the fund has to keep some cash on hand, so some small percent of your money isn’t actually invested. If you invest in mutual funds in a taxable account, the churn in fund holders’ redemptions create trades that cause capital gains, which creates taxable income for the fund as a whole. It will be a small percent, but it will still be there (on top of taxation of any dividends). This is because the legal model applied to your investment is like you are a partner in a partnership, where you get an allocation of profits and losses that are separate from your receipt of cash.
Buy an exchange traded fund that mimics the index you want to buy. These are still mutual funds in operation. The main difference here is that the shares in the fund are themselves tradable. Theoretically, I think this means that the fund does not have to redeem as much, so it can hold much less cash. It would do redemptions if people were bailing out of the market generally, so that sellers outnumber buyers. But the issuer can essentially make money by arbitraging any difference, which means effectively redemptions pay for themselves. Being exchange traded means that the mutual funds have to make some additional SEC filings, but these have become routine once EFT’s became popular, and the costs are spread over a truly vast number of people. The other main difference is that you only pay taxes on capital gains when you sell your ETF shares. That is because the legal model treats an ETF like an investment in a corporation, where the corporation’s profits and losses are not attributed to you, and you only get something when you get cash.
You can also buy all the shares yourself, which is something called a “synthetic” fund sometimes in rarefied circles. It eliminates all of the potential capital gains taxes until you sell the underlying assets, but it means that you have to buy a set of shares that would be really expensive and only comes in oddly sized chunks. For example, if you want to buy the stocks in the Dow Jones, that is 30 different stocks, any you would have to buy one of each. That might cost you $1,531.72. Who wants to buy investments at a price of $1,531.72 per unit? What do you do if you have $1,500 or $1,600?That is why ETF’s are so attractive. They get all of the convenience of the mutual fund, the capital gains tax treatment of owning shares directly. Index funds, whether regular mutual funds or exchange traded funds, also have the benefit of spreading fixed costs over huge numbers of people, so the expenses are usually very low.
Exchange traded funds are actually a little more clever than that. From the fund’s perspective, it doesn’t redeem fund shares for cash. The ETF has a number of “authorized participants” which are banks that can create new shares of the ETF. To create new shares of the ETF, they purchase the underlying shares in large quantities (called a “creation unit”) and provide them to the ETF, which then gives back the authorized participant the matching number of ETF shares. So for an S&P 500 ETF, the bank would first purchase all of the underlying shares of the S&P500 in the right quantity (generally a very large quantity) and provide them to the ETF, and the ETF would hand them X number of ETF shares that the bank can now sell. The banks make money through arbitrage, by buying and selling creation units when they are out of alignment with the price of the ETF.
A synthetic fund is slightly different from your description. A synthetic index is when you use derivatives to replicate the performance of an index fund. So rather than taking your $100 million charitable endowment and invest it in an index, you take your $100 million dollars and invest it in treasury securities, then enter into a swap contract that will replicate the perfomance of the index. Future payments go into your fund, and future shortfalls are removed from your fund. It can also be done with futures and the like.
Anyone know how much this is applicable to the UK?
It is very applicable to the UK. sixes_and_sevens document is a good start, but note that there is a whole world of online platforms now (Hargreaves Lansdown, Bestinvest, etc) which can be much more convenient and give you more control.
Note that there is SDRT of 0.5% on UK equities, which you will likely pay as a secret hidden tax on your index fund—the more ethical companies, such as Vanguard, make this clear—so you may wish to choose your index fund to avoid this pernicious tax. If you work in the UK, you are probably implicitly overexposed to the UK economy anyway, so this is an argument to track a global, non-UK stock index.
Most of the information on index funds that has been provided in this thread, and in links from this thread, is applicable to the UK. I suspect all the information you’re likely to retain, and need, is applicable.
Here is a quick-and-dirty document I threw together for London LWers looking to invest in index funds but not knowing where to start. There are better guides out there but they are necessarily longer. Googling “UK index tracker” will get you quite far.