Index funds, explained once

Contents

• 00:00 — What a fund is, before what to buy
• 05:45 — What an index actually is
• 13:20 — The list, and who writes it
• 23:00 — Where the fee goes
• 33:25 — Why fees compound in the wrong direction
• 44:10 — Active management, and why he stopped
• 53:50 — What to do this week

Transcript

Yara Mensah: I want to do this from the bottom. Not what to buy — I never say what to buy. Just: what is the thing.

Rahul Iyer: Then we can do it in about ninety seconds. A fund is a pot that a lot of people pay into, and the pot buys things, and you own a slice of the pot proportional to what you put in. That is all a fund is. Nothing about that word is complicated; it has just been used near complicated words for so long that it caught the difficulty.

Yara Mensah: And an index?

Rahul Iyer: A list. Somebody writes down five hundred companies, or three thousand, according to a published rule — usually the biggest ones in a particular market. That list is the index. It is not a thing you can buy. It is a list.

Yara Mensah: So an index fund is —

Rahul Iyer: A pot that buys the list. Every company on it, in the proportions the list specifies. When the list changes, the fund changes to match. Nobody is choosing. That is the whole product.

Yara Mensah: Let me stop you, because "tracking" is a word that appears everywhere and I have never heard anybody define it.

Rahul Iyer: Following the list. If the list goes up four percent, the fund is trying to go up four percent. It is not trying to do better. Trying to do better is the other kind of fund, and it is a different job with a different price.

Yara Mensah: Right. Let's talk about the price, and can we do it in dollars, because percentages are how I lose people.

Rahul Iyer: In dollars, gladly — I think percentages are the single biggest reason people cannot see fees. Invent a number: you have $10,000 invested. A fee of one percent is $100 a year. A fee of a tenth of a percent is $10 a year. Those are made-up round figures, I am doing arithmetic rather than describing any real product.

Yara Mensah: And that difference sounds small.

Rahul Iyer: Ninety dollars sounds like nothing. Here is why it is not. The $90 does not just leave — it leaves and it stops being invested, so it never grows again. Next year you pay the fee on a slightly smaller pot, which is slightly smaller again the year after. The fee compounds against you exactly the way the returns compound for you, and it does it with total reliability, which the returns do not.

Yara Mensah: Say that last bit again.

Rahul Iyer: The growth is uncertain. The fee is certain. Over thirty years you are comparing something that might happen with something that definitely will. That asymmetry is the actual argument, and it is arithmetic — it does not require anybody to have a view about markets.

Yara Mensah: Go back to the list for a second, because I skipped something. Who writes it?

Rahul Iyer: A company. An index is a product somebody publishes, with a rulebook: these are the criteria, this is when we review, this is what happens when a company no longer qualifies. It is not a natural fact about the world. It is a document with an owner.

Yara Mensah: That is not what it sounds like. It sounds like weather.

Rahul Iyer: It sounds like weather, and the language encourages that — "the market was up" — but somebody chose the boundary. Change the rule about how big a company has to be, and "the market" is a different set of companies. I am not suggesting anything sinister; the rules are published and dull. I am saying that a list has an author, and knowing that stops you treating it as a law of nature.

Yara Mensah: Does the fund pay to use the list?

Rahul Iyer: It does, and that licence fee is part of what you are paying for. It is small. But it is one of the reasons a very cheap fund is cheap and not free.

Yara Mensah: What happens when the list changes?

Rahul Iyer: The fund buys and sells to match, on the day the rule says. And that costs something too, and it is not in the headline fee — trading has a cost of its own. This is where "cheapest" gets slightly less simple than the number on the page, and I want to be honest that the ninety-dollar arithmetic I did earlier is a simplification.

Yara Mensah: Is the simplification misleading?

Rahul Iyer: No, because the extra costs are small and they push in the same direction. It would be misleading if it flattered the argument. It does not — the real gap is a bit wider than the headline fees suggest, not narrower.

Yara Mensah: So why does the expensive kind exist? You ran one.

Rahul Iyer: I did, for eleven years, and I want to answer this without being either defensive or theatrical about it. It exists because the promise is genuinely attractive: pay more, get somebody clever choosing. And some do beat the list. The difficulty is that you have to pick which ones in advance, and past results are a famously poor guide to that.

Yara Mensah: Were you good at it?

Rahul Iyer: Some years. And the years I was good, I could not always tell you why, which is an uncomfortable thing to notice about your own job. What I could tell you exactly, every year, was what we charged. When I worked out that the fee was the only part of the arrangement I could be certain about, I stopped being able to argue for it — for myself, I mean. I am not telling anybody else what to hold.

Yara Mensah: One more, because people will be shouting it at the radio. What about when everybody owns the list? Does that break something?

Rahul Iyer: It is the best objection and I want to give it a real answer rather than bat it away. The worry is that if enough money simply buys the list without asking whether anything on it is any good, prices stop reflecting judgement.

Yara Mensah: And?

Rahul Iyer: And it is a genuine open question. What I would say is that the price is still set by the people who are trading actively, and there are a great many of them with a great deal of money and a strong incentive. If the passive share ever got large enough to blunt that, the reward for doing the work would rise, and people would do the work. It is somewhat self-correcting.

Yara Mensah: "Somewhat" is doing some lifting there.

Rahul Iyer: It is, and I would rather leave it doing that lifting than pretend I know. What I will not do is use the objection the way it is usually used, which is as a reason to pay more. "Passive investing might have a systemic problem" is not an argument that any particular expensive fund is worth its fee.

Yara Mensah: So this week?

Rahul Iyer: Find the fee on whatever you already have. A workplace pension, an old account, anything. It is on the statement or in the documents, usually called an ongoing charge. Do not change anything, do not move anything. Just find out what number you are paying, because most people genuinely do not know, and it is the one part of this that is knowable.