3 things you need to know about index investing

In case you are not aware, there are now 70 times more stock indices than listed stocks globally. This is partly driven by the growth of passive investment strategies, which for the first time overtook their active counterparts for the first time in 2024, according to Morningstar.

However, as index investors, it is important to understand the underlying index you are investing in, how it is constructed and whether there are any potential risks you might not be aware of.  Let’s take a closer look at the basics of an index fund and 3 key things you need to know about index investing.

Back to basics: What is an index fund?

An equity index refers to a hypothetical collection of stocks or investment holdings that represents a segment of the financial market.

For example, the Hang Seng Index (HSI) tracks the largest and most liquid companies listed on the Hong Kong Stock Exchange (HKEx),  while the S&P 500 index tracks the 500 largest companies listed on the stock exchanges of the US.

An index fund is a mutual fund (also known as a unit trust) that aims to track the performance of a market index by investing in all or part of the constituents of that particular index (more common for bond index funds), rather than trying to beat the index’s performance. 

Learn more: Why passive investing beats trading

Now that we have the basics out of the way, let's look at the three things you need to know about equity indices before you begin index investing:

1. Weighting method of indices

There are two main types of weighting methods: market capitalisation and equal weightage.

To illustrate this, let's assume we are investing in a hypothetical "BAT China Internet Index Fund", which is composed of three large China internet stocks (Baidu, Alibaba, and Tencent).

Understanding weightage through the hypothetical BAT China Internet Index Fund:

Market capitalisation basically refers to the value of the shares that are available for trade on the stock market exchange. The higher the share price, and the greater the number of shares available for trade, the higher the market capitalisation. As a result, when the share price increases or when new shares are issued, the weightage will change.

However, for an equal-weighted index, the weightage of the stocks will always be the same within the index, regardless of their share price movements

Because of the different weightage, the risk and performance of the same equity index could be completely different, despite having the same underlying shares.

For example, the S&P 500 is a market-cap weighted index. Some investors have raised concerns about the concentration as the result of such market-cap weighting. 

Due to the strong performance of large tech companies in recent years, particularly the Magnificent Seven, these 7 stocks account for 30% of the S&P 500 index as of March 2024.  And investors might not reap the benefits of diversification from passive index investing.

As a result, some fund managers have issued equal-weighted versions of the S&P 500 index funds/ETFs as alternatives for investors to consider.

Below are some common indices and their construction methodologies:

2. Sector and geographical exposure of the equity indices

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The exposure type and geographical exposure of the funds let us know how the equities are classified, and which category of index investment we are investing in.

For Hong Kong index investors, the Hang Seng Index seems like an intuitive choice to invest in. It is denominated in Hong Kong dollars and has many blue-chip companies investors are familiar with.

However, local index investors have to take note of the concentrated exposure of HSI — it is made up of about 80 HKEx-listed companies, with a large exposure to sectors such as financial services and property. 

Read more: Understanding home bias amongst Hong Kong investors

Investors looking for diversified passive investing strategies to invest for the long term through market cycles could consider index funds that track broad-based indices, such as the MSCI All Country World Index and the FTSE All World Index.

The more specific the index criteria, the smaller the number of portfolio assets that can be under the index and could defeat the benefits of diversification via passive investing. That also brings us to the next point.

3. Tracking error and potential active risk in your “passive” index investment

The most important point for index investors is to understand not just the exposure type and geographical exposure of the index funds, but also the investable universe of the index and how closely it tracks its benchmark index.

Tracking error refers to the difference between an index fund and the benchmark index tracked by the fund. 

Take an example, suppose the MSCI Emerging Markets Index gained 3.5% in a given month, on the other hand, the NAV of an index fund which tracks the index gained 3.3% during the same period. This difference of -0.2% (3.3%-3.5%) is the tracking error of the index fund. A tracking error can be both negative or positive if the index fund outperforms its benchmark.

Tracking error can be caused by transaction costs, management fees, cash balances maintained for potential redemptions or inability to buy and/or sell the certain underlying index instrument. 

Particularly for fixed income, due to the negotiated structure of the market, it is almost impossible for index managers to 100% replicate a bond index. Instead, the best they can do is sample a portfolio that matches as closely as possible to the index’s duration, credit quality, and yield.

Read more: Passive investing for stocks, but how about bonds?

Index investing might also have an embedded active element. For example, Hong Kong’s Hang Seng Index is subject to a quarterly review regime. The index provider is responsible for adding or removing companies from the index based on factors such as market capitalisation, liquidity, sector representation, and more.

With the emergence of many new indices, they might also be constructed using proprietary methodologies of index companies. The same ESG indices might comprise varying underlying stocks based on different screening methodologies by different index companies.

With a clearer understanding of how index investing works and key considerations to look out for, let’s see how you can compose your own index investing investment portfolios.

Get started with index investing through Endowus

At Endowus, we work with global leading fund managers to screen and bring in low-cost, Best-in-Class mutual funds to Hong Kong investors. We do not charge any subscription fees, or switching fees and pioneered industry-first 100% trailer commission rebates to lower costs of up to 50% less than the industry average for Hong Kong investors.

That allows our clients to be exposed to the markets in the most cost-efficient manner, even cheaper relative to ETFs at times, and translates to higher returns over the long term.

If you're interested in investing in an index fund, explore the list of curated investment funds on the Endowus Fund Smart platform.  For those keen on getting exposure to top US stocks, you can get exposure to the S&P 500 with the HSBC Asset Management’s US Equity Index Fund. 

Professional Investors can also get access to a broader range of passive investment strategies offered by Blackrock iShares and Amundi. 

You can buy a single fund or customise your ideal portfolio with multiple funds through Fund Smart in just a few minutes. 

Click here to get started with Endowus Hong Kong today.

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