The other day, I was trying to explain to a friend why I invest in index funds. I came up with this example, which I’m not sure is perfect but I thought I’d share it.
Background: Market Cap Indexes
When you hear “index funds”, it traditionally means mutual funds that follow an index which holds companies proportionally to their market capitalization. If a company has 1,000,000 shares and each share is trading at $25, then its total market capitalization is $25 million.
Let’s take the S&P 500 Index. The market cap of Starbucks (SBUX) is $14 billion dollars, while Exxon Mobil (XOM) is worth $334 billion. So an index fund tracking the S&P 500 would hold 24 times as much Exxon as Starbucks.
The index fund is “passively managed” in that it does not make any of its own decisions on the value of each company, it simply accepts the value of the each company as determined by each day’s market trading between millions of investors.
An Alternate Universe
Let’s imagine an alternate universe where we only have two companies, AAA and ZZZ, that make widgets, the one thing people there buy. Both have a million shares outstanding. Company AAA makes widgets and has earnings of $1 million a year. It’s been around a while and is fairly boring, so the price/earnings ratio is 10, making the market cap $10 million. Thus, each share is worth $10.
Company ZZZ also makes widgets and has earning of only $500,000 per year. But it’s newer and makes stylish widgets that attract young people. People seem to think it has greater potential for earnings growth, so the P/E ratio is 20. Thus, the market share is also $10 million, or $10 per share.
An index fund is created to track this alternate universe, and based on market-cap it holds 50% AAA and 50% ZZZ.
So what happens in the future?
ZZZ could keep taking market share from AAA with their cool and stylish widgets. AAA’s earnings go down to $500,000, and the P/E stays constant at 10, leading to a new market cap of $5m. ZZZ starts earning $1,000,000 per year, and with a P/E of 20 grows to a market cap of $20m.
What happens to the shares in your index fund? Nothing. No trades are made, because only the share values have changed. You hold the same number of shares of each. However, your fund’s value has grown 25% because the value of ZZZ has doubled, while the value of AAA has been cut in half. Your holdings based on market value are now 20% AAA and 80% ZZZ.
Things are going along, but then a new medical study finds that ZZZ’s widgets cause cancer, and it turns out the CEOs have been covering this up for years. ZZZ tanks, and is now trading at a penny per share, while everyone is switching to AAA’s reliable widgets. AAA goes up to a market cap of $25m ($25 per share).
What happens to the shares in your index fund? Still nothing, even though you now own 99.96% AAA. Meanwhile, your fund has grown another 20% because of AAA’s growth, even with ZZZ’s collapse.
You don’t know what is going to happen in the future. There are a million different possible scenarios I could have chosen. AAA could have split off a small division called BBB and it could have taken over the world. The most important point is, whatever happens, with a market-cap index fund, you are guaranteed to own all the winners.
You’ll also have owned the losers, but remember you won’t know who they are beforehand. Buggy whip manufacturers used to be huge. Now, iPhone-making companies are growing. One day iPhones will be in landfills, and we’ll be onto downloading knowledge directly into our brains or something. Or maybe we’ll run out of oil and be back to buggy whips. Who knows.
“Don’t look for the needle in the haystack. Just buy the haystack.” – John C. Bogle
This is the power of passively-managed index funds. With low-cost index funds, you’ll even be guaranteed to beat the average investors’ performance because of investment expenses eating into their return.
By Jonathan Ping | Investing | 8/10/09, 6:20am