Index Funds & ETFs - A Slice of The Market

I have always considered myself a dog person, but there is one famous cat that I can deeply relate to – Garfield. His distaste for Mondays is something I can resonate with. In fact, I also share his affection for Italian cuisine so some may say that we are very much alike.

However, while Garfield likes to indulge on lasagna to get through a Monday, I pick a different dish from our friends across the Atlantic – a meat lovers pizza. More specifically, I pick one up from the local pizza shop down the street – Dominoes.

What is it about the pizza that comforts me at the start of the week? Maybe it’s the consistency of the crust. Maybe it’s the plain sauce that is brought out by the cheese. Maybe it’s the risky play of all the meats – big hits or big misses.

In isolation each of these ingredients are fine, but the magic happens when they are brought together and baked in the oven.

Just like the pizza is more than the sum of its parts, ETFs and Index Funds are the same!

The MeatZZa

To help it make sense, come with me on my trip to Dominoes. When I go pick up my meat lovers’ pizza, I understand the ingredients very well.

The Crust – consistent, garlicy, classic Dominoes. No surprises

The Sauce – boring, bland, but needed to bring the ingredients together

The Cheese – okay on its own, but paired with the sauce they work great

The Toppings – hit or miss, but when good, make the entire pizza worth it and more

While these ingredients have a different influence on whether I think a specific meat lovers pizza is “good”, a good crust, good sauce, good cheese, and miss on toppings can still deliver on okay pizza. However, good crust and good sauce with undercooked cheese and bad toppings isn’t enough to save the pizza – I would consider that a bad pizza.

This isn’t an exercise on me being a fast-food pizza snob. This is an exercise on risk mitigation. I am not evaluating whether each individual ingredient is good or bad, I am evaluating whether the bundle of the ingredients is good or bad in aggregate. Toppings having a bad day can be mitigated by all the other ingredients playing their part well.

The Needs for Funds

Traditionally in the investment strategy tabbed “stock picking,” you would pick individual companies and bet on them raising their stock price.

For example, if I buy shares of Coca Cola stock at $65 a share, I am betting that Coca Cola will perform at an operational and financial level that will increase the right to collect their cash flows above $65 per share.

I discuss both stock types and the basics of stocks in my TSR and Trilogies articles and would encourage you to check those out!

However, if Coca Cola does poorly, then my investment could lose value or even go to $0! Betting on individual companies is risky unless you understand what drive fundamental performance and value for each company as well as knowing what Wall Street expects from them.

That’s why ETFs and Index Funds exist. It is very difficult for someone that is not watching the markets daily to pick stocks and reconfigure their portfolio.

I promise I won’t nerd out TOO much on finance, but this relates to a principle created by Harry Markowitz called Modern Portfolio Theory (MPT). MPT argues that the best way to mitigate the risk is by diversifying assets in the portfolio. Then, if one asset goes down, it could be mitigated by one going up.

In essence, Markowitz argues that you should bet on whether the pizza will turn out good, not cast individual bets on whether each ingredient will be good.

This is where it is important to understand the consistency of dividends stocks and the upside of capital gains stocks. ETFs and Index Funds carry both together that allows for the stability of the dividend stocks to mitigate the volatility of the capital gains for long-term growth and stability. The value of these baskets are derived of the aggregate of all the stocks in the basket.

The Grocery Store

All of us have been to a grocery store and picked items off the shelf. Whether the items you picked were motivated by a list you made, a list someone else made, or even ingredients for a dinner you were craving, there were motivations for picking the items.

The baskets of these stocks are no different. Investment professionals compile these baskets and use them to track well-known indices like the S&P 500 or the DOW (which are also baskets of stocks used to evaluate the health of the economy) or even capitalize on thematic trends such as baskets that only hold tech stocks, African growth stocks, or even track with other traders or politicians.

However, at the grocery store the process doesn’t start by picking ingredients, it starts with picking the type of basket we put the ingredients in. We can pick a shopping cart which is slower, moving but great at holding lots of items and allowing us to not worry about capacity. We could also pick a shopping basket which is smaller, more mobile, but we must be more mindful of capacity.

Index Funds are your shopping carts while ETFs are your baskets.

Index Funds

The mechanics of an index fund are relatively straightforward. Millions of individuals give money to a fund manager to go and buy stocks on the market and create a basket of stocks that mitigate individual risk. In turn, the manager takes a percentage of capital gains as payment for their services, and individuals get risk mitigation they could not create themselves.

I could not purchase all 500 stocks on the S&P 500 ($50 Trillion Value) by myself. Funds can get much closer than myself in trying to mirror the index.

Index Funds settle at the end of the day and trade based on dollars not shares. Simply put, individuals give dollars to the fund manager, and the fund manager takes those dollars, sees what they can buy to try and maximize risk/return, and rebalance the portfolio by the end of the day. The capital gains and distributions are based off the dollars contributed by everyone.

The benefit of this is that investing is easy. An individual could automatically have $100 from their paycheck invested in an S&P 500 index fund and see $100 come out of their bank account with every draw. This also works if someone gets birthday money from grandma and wants to make a random $50 investment in their index fund. A good way to think about these is these are “sit it and leave it” investment options. These are intended for long-term investment, and some people don’t even look at the value of these until they get closer to retirement.

The downside is that these do not trade with velocity. In other words, they do not trade quickly. They take end of the day settlement. For example, if an individual wants to withdraw $100 worth of value from this fund, they must put the order in throughout the day before market close and may not see the funds in their account until 2-3 hours after market close. Since these are traditionally seen as “sit it and leave it” investments that will not need to be pulled in a rush, these serve their purpose.

ETFs

Exchange Traded Funds address the velocity issue discussed above. Funny enough, I have a friend of mine that actively trades his S&P 500 ETF, selling it when the market heats up, then buys shares back when it crashes. He would even sometimes do this intra-day. ETFs are valued like stocks. I do not set buy order in dollars; I set it in shares. For example, if I wanted to buy $100 worth of an ETF, if it is worth $45 per share I would buy 2 shares ($90) and keep the remaining $10 until I have enough to buy an additional share. You have to be mindful that if you want to cleanly buy shares you may not be able to invest the full amout immediately.

However, the benefit is velocity. I can trade this intraday with immediate settlement like stocks. If I want to pull my money from the ETF at 10:00 AM I will see the funds hit my account at 10:01 AM or sooner! While for most retail traders, ETFs should strategically be the same as index funds (“sit it and leave it” investment) some individuals like to trade them actively.

Buying Your Own Pizza

Whether you invest in index funds or ETFs, the goal here is to bet on the pizza. Stock picking is risky and traditionally why most individuals try and stay away from the stock market, but investing long-term in a diversified fund allows for risk mitigation while capturing the gains that investors get from equity. However, it is key to note that equity investing should be done with money you do not need right now – even in diversified funds the price can swing up and down in the short-term.

So next time you’re at a family gathering and your cousin is trying to pitch you on an emerging markets data center ETF, at least now you’ll know what he’s talking about to pair with your skepticism. At the end of the day, it’s all pizza. Now that you know that you’re ready to think about what slice of the market you want to look at.

But if it’s Monday today you can maybe wait until tomorrow. For today, get lasagna and a meat lovers pizza. It’s what Garfield and I would want.