A couple of weeks ago, I was having drinks with a friend from the finance industry. The conversation turned to passive investing and we spent a bit of time discussing one particular index fund in my portfolio.
The following morning, he texted me with a simple question:
“How do I find a fund that will give me the same exposure?”
It should have been a very easy question to answer. However, what actually followed was a highly frustrating sequence of WhatsApp messages and phone calls.
It took us the better part of the morning to find a simple tracker fund in my friend’s brokerage account.
As it often happens with many other things in life, when it comes to index fund investing the last step is often the toughest.
You have done your research and are convinced of the merits of passive investing. You have gone ahead and opened an account with a low-cost brokerage. You have even deposited some money.
And then, just when you are finally ready to hit the big red button, you realize that the biggest question remains unanswered:
Which Index Fund Do I Actually Buy?
There is a reason for that, of course. In a world where trading fees have finally begun to vanish, brokerages are even more focused on finding alternative sources of income.
One solution is to act as a bank and try to make money on the cash balances your investors hold with you.
Another one, of course, is to go back to the basics of making money in the brokerage business: selling people like you and I expensive financial products we don’t need.
And that is precisely why you rarely see low-cost, passive investing products featured prominently on the home page of any brokerage. Instead, they are usually hidden way behind the hundreds of shiny, expensive and utterly useless actively managed options.
So how do you cut through the noise and find the right index fund to put your money in?
As my experience above has shown, even someone with 15+ years of stock market investing experience can struggle to find the right product.
So a few days later I sat down on a rainy Saturday afternoon to put together a step-by-step guide to finally getting your passive investing journey underway.
To do that, I will replicate the steps necessary to find – and invest in – an index fund that tracks the performance of the S&P 500.
An Aside – Why Did I Choose The S&P 500?
If you go back to the basics, the core idea of index fund investing is to put your money into a globally diversified portfolio of equities.
So why am I choosing the S&P 500 instead of a more diversified index such as the S&P Total Market or the FTSE All World Index?
There are three reasons for this:
When it comes to investing, it’s important to keep things simple. Otherwise, chances are you will never get started.
S&P 500 tends to be a good index investment for beginner investors because of its ubiquity, simplicity and the sheer number of index funds that track it.
2. Global Diversification
According to S&P Dow Jones and Factset, the S&P 500 constituents generate c.25% of their revenues from outside the US.
Therefore, even though you are technically investing in a US index, you are getting a considerable amount of global exposure.
3. Better Governance
Very few regulatory regimes in the world offer the same level of shareholder protection as the US.
So while exposure to global equities is great, it often comes at the price of shareholder value leakage due to management corruption and mismanagement.
Petrobras is a great example.
Sure, the same issues could always arise at an S&P 500 constituent. However, I see that as much less likely given the level of public scrutiny and oversight these companies are under.
Of course, if you want to invest in a UK or a global tracker, that’s perfectly fine and you can still follow all the steps below.
A Step-by-Step Guide To Finding The Right Index Fund
Because I already have an account with Hargreaves Lansdown, this will be the brokerage I will use in this guide.
However, you should be able to follow broadly the same steps even if you have an account with other brokerages.
Let’s get started!
Step 1: Search for funds investing in North America
This is the simplest bit. Go to Hargreaves Lansdown and log into your account. You will be presented with this screen:
Click on Funds at the top of the page (see big red box above).
You will be redirected to the Funds – Prices and Research page that looks like this:
Click on the “Search By Sector” dropdown box and choose “North America”:
Once you have done this, you will be presented with a long list of funds that invest in North American equities. As a matter of fact, the list that popped up on my screen had 132 names on it!
Most of these will be actively managed funds with convoluted naming conventions and strategies.
With names like “Artemis US Extended Alpha (Class I) (Acc)”, it’s no wonder people get confused!
So what we need to do now is whittle down the long list of names to just a handful of funds that actually fit our objective.
Step 2: Shortlist the funds by company name and annual charge
Thankfully, this step is much easier than it sounds.
On the left-hand side of your screen, you will have an option to sort through the funds by choosing the investment company that offers them:
Expand the menu by clicking on “View All”. Then choose the three most prominent companies offering passive investing products. These are:
The list of funds should reduce from 132 to about twenty.
However, we can shorten it further still.
Please go the “Refine” column on the left-hand side of your screen again. Scroll down to the “Charges” section and under “Ongoing Charge (OCF/TER)” heading click the box next to “<0.5%”.
Anything with an annual charge of 0.5%+ is likely to be either actively managed or a very expensive passive product. If you’ve gotten this far, you probably know that’s not a good thing.
Now that you’ve selected the “<0.5%” option, your list is down to a much more manageable 9 index funds:
Take a quick look at the list.
The one that immediately jumps out is the “Vanguard US 500 Stock Index (Acc)”. Click on the fund name, which will take you to the fund overview page.
Look for the “Fund Objective” section and sure enough, this is what you see:
Let’s now scroll through the other 8 funds to see if any others have the S&P 500 as the underlying benchmark index.
Sure enough, there are two others:
- Fidelity Index US Class P – Accumulation
- Fidelity Index US Class P – Income
At this stage, you may be wondering what “Accumulation” vs “Income” is.
The answer is simple. In an Accumulation fund, all the dividends are automatically reinvested. In an Income fund, all the dividends are paid out to fund holders (i.e. you), as income.
Hence, the performance of an Accumulation fund will track the total return of the underlying index (in this case, the S&P 500). The performance of an Income fund will track the price return of the underlying index.
In this guide we are looking for accumulation units. Therefore, the two funds we have shortlisted are:
- Fidelity Index US Class P – Accumulation
- Vanguard US 500 Stock Index – Accumulation
Step 3: Compare the fund charges
If you click on the fund name, you will be taken to a fund overview page.
On the left-hand side of this page, you will see a comparison of initial and underlying charges. As we all know, lower is better.
Neither fund has an initial charge, but when it comes to an annual charge, the Fidelity fund has a charge of 0.06%, which is significantly lower than the Vanguard annual charge of 0.25%.
Should we go ahead and buy the Fidelity fund?
Not yet – we have one final check to do.
Step 4: Check fund tracking error
When it comes to passive investing through index funds, it’s important to make sure that the funds you are buying do a good job of tracking the underlying benchmark index.
There will always be a small discrepancy, which is also known as a tracking error. It is the job of the fund manager to minimize this tracking error.
So before we buy the Fidelity fund, let’s see how well it has been tracking the S&P 500. To do this, go to the Fidelity fund overview page and click on “Charts and Performance”:
Scroll down the page and under “Add to Chart” tick the box next to “Index”. Then choose the S&P 500 from the dropdown menu and tick “Total Return” under “Chart Options”:
You should get a chart that looks like this:
The orange line is the performance of the Fidelity fund while the blue line denotes the performance of the S&P 500 over the same time horizon.
As you can see, the two have moved in unison for an extended period of time. This means that the tracking error is minimal.
Alternatively, you could click on “Key Features And Documents” on the fund overview page, download the Fund Factsheet and check the tracking error statistic in the document.
Voila – the tracking error stands at about 0.06% over the past three years:
There you have it.
In just four easy steps and less than 10 minutes, you found an index fund that tracks the benchmark index you wanted to get exposure to, has the lowest fees and a minimal tracking error.
You are done.
All you need to do now is actually buy the fund. You can do that by clicking on “Invest Now” and following the instructions:
Happy (passive) investing!