How To Create An Index Fund | How Profitable Is An Index Fund

August 6, 2021 Angel Investing Education No Comments

How to create an index fund and How profitable is an index fund?

When the economy is heading south and the stock market has slipped, a mutual fund can be quite risky and expensive.

When the market is rising and the stock market is slowing, an index fund is one of the easiest ways to make money. This is because, as the stock market rises, the value of the mutual fund goes up, but not as fast.

But then this isn't a straight line rise either.

An index fund is similar to a market sector, so a mutual fund needs to track the market or it will underperform.

How To Create An Index Fund

When it comes to creating an index fund, I think it is essential to include an important component. Not just price movements, but also volume movements.

Volume is important, because when a stock makes a big move, usually it has more buyers than sellers.

So it is important to have an index fund that mimics the volume of the market, so if the market makes a big move, then the index fund will be on board.

If you don't have access to an order entry system, then the only way to create an index fund is to manually enter each stock on a daily basis.

Of course, you are also interested in how profitable it will be.

There are a couple of ways to measure profitability. The first is called return on equity, or ROE.

Cash Equivalents And Marketable Securities

It is essentially the stock's equity after deducting all cash, cash equivalents and marketable securities. This is useful for looking at how well an index fund will perform compared to the market. The next is called return on investment, or ROI.

It is basically the net profit after deducting the total costs of running the fund.

A better way to create an index fund is to simply buy a few stocks that are good (at least according to the ROE) and simply hold them. Keep the costs low by only buying good companies, and let the market do the rest.

This is the approach I used to create my index funds, and I have been very happy with the returns.

With all index funds, you need to set yourself a price target to buy. If the stock falls to your target price, then sell. If the stock goes higher, then buy. Never chase prices, as you will lose more money than if you let it ride.

Trailing Stop Losses

And remember, even index funds have trailing stop losses, so you can't let it fall into disrepair. Set your target at 2% below, and 3% above its current price, so you will be fully invested in every move up or down. And remember, you will have room in your portfolio to exit when things go wrong.

With these rules in place and the benefit of hindsight, you will certainly be much more successful than the majority of investors out there.

For the purposes of this article, let's assume that we have the following index funds: Fund Yield = 6% Yld=20% Fund Yld=100% Fund El=15% Fund Sld=0%.

Now, let's use an alternative approach and calculate total fund costs, including management fees: Fund Yield=20% Yld=100% Fund Yld=100% Fund El=15% Fund Sld=100%.

To create these funds, we only paid an annual management fee of 0.75%, and we also paid a total fund cost of $15,000 (plus expenses). It is easier to see how to compute total fund costs using a table, so I will not repeat it here.

The numbers are much easier to calculate from a table than from the net result, but there is no guarantee that the above amounts will precisely reflect the total costs.

Create A Portfolio Of Index Funds

How to create an index fund, I have used these figures in order to demonstrate how the portfolio can create a portfolio of index funds that will have costs at all times less than 6%, a target rate of at least 20%, and an investment return of at least 100%.

Note that this approach is best for a passive investor who wants to see the overall direction of the market. They can leave the day-to-day management to an index fund, and not need to check it every day.

I should mention the third approach when asking how to create an index fund, using derivatives. You could create a new fund for each market, sector, or energy, but for simplicity, we will keep things simple and say that we want one fund for each.

The Derivative

We can then look at how much this approach adds to the cost of our portfolio.

The first step is to look at how many derivatives we will use.

We can then determine the cost of the derivative, and then look at how much this approach adds to our cost.

The following two steps are simple arithmetic, and easy to calculate.

* Determine the total cost of adding derivatives.
* Multiply the total cost by a total number of derivatives, and add them together.

Let's say that the total cost of adding a single XF with another is $100. Multiply this by 2, and we get $200. Add this to our portfolio, and we have a total cost of $800. This is easier to do than calculating.

I used an actual trading system for this example, as such the numbers might be off a bit. However, our approach is easily reproducible and replicable, and this example should give a good grasp of how our approach works when researching how to create an index fund.

There is another approach on how to create an index fund, which uses index funds to make up the portfolio. Since this approach is more complicated, I will not go into details on it in this article, but you can look into it if you wish.

How Profitable Is An Index Fund

How profitable is an index fund over long periods of time?

How profitable is a buy and hold strategy?

Are they equal?

Are they different?

How much should you spend on index funds and how much on buy and hold?

There are various ways of calculating the profit of an index fund. This method of calculating profit is sometimes called the value-weighted or earnings weighted method of calculating profit.

Value Weighted Method

How to create an index fund, This is the method used by the majority of fund managers.

For this method, a portfolio of stocks or mutual funds is divided into ten equal parts each of which represents a per cent of the portfolio.

A value is assigned to each part based on the market conditions in effect at that time.

These market conditions can include sector and individual stocks. If there is a bullish market, the value of one part of the portfolio is increased while that sector and individual stocks become weaker.

If there is a bearish market, the value of part of the portfolio is decreased. The tenth part of the portfolio is assigned zero value. The average return then is taken off the portfolios returned since the division of the portfolio.

Profit Number Method

Investors who use this method have picked one or more stocks or mutual funds and assigned a value to each.

They then look at the return earned by these stocks or funds over a period of time. If these returns are greater than the average return of the portfolio they are credited with a positive number.

If they are less than the average return of the portfolio they are dropped.

Market Cycle Method

The market cycle method is just the opposite of the value-weighted method.

The stocks or mutual funds are divided into 10 equal parts and each part is assigned a value based on the market conditions in effect at that time. If the market conditions change, each part of the portfolio is assigned a value that reflects the change.

For example,

if the economy is doing well and stocks are moderately valued, the part of the portfolio that includes stocks that are considered moderately priced will be increased by a number that reflects the changing market conditions another consideration with how to create an index fund.

Triangular Method

The investors choose a stock or mutual fund, which they believe will have the highest probability of success in the next bearish or bullish market conditions.

The investor then divides the portfolio into three parts based on how likely they are to succeed in each part. Then the investor looks at the average return of the portfolio.

If the average return is greater than the average return of the whole portfolio, then the last part of the portfolio is increased by a number that reflects the change.

For example, if the average return of the whole portfolio is 6%, then the last part of the portfolio is increased by 6% due to the average return of the whole portfolio being greater than the average return of the last part of the portfolio.

The three methods for calculating expected value give a number called the expected value that you can use to trade the market.

But what is important to remember is that the different methods give you a number that you can use to compare different strategies.

Buy and Hold Method

This method is also used by the majority of fund managers. Basically, you buy and hold the fund.

Over a period of time, the market price moves upwards and you add the current price of the fund to the current market price and you get the cumulative sum of all your buys. You then subtract the cumulative sum of all your sells and you get the value-weighted profit.

You take the lower value and you now then multiply that by the years of highest market price to get the profit.

Note: if you were to buy and hold the fund for a total of 25 years and then sell it, the fund manager would add the two cumulative prices and give you a profit of 2*(1-a-b)).

The question is, are these methods equal?

How much should you invest in index funds and how much should you invest in buy and hold?

You might be surprised to hear that these aren't the most important questions facing individual investors.

Even though these two methods of investing have long been heralded as the best way to generate guaranteed profits, many individual investors still fail to achieve the desired level of diversification required to beat the market.

If you were to ask any individual investor how much he or she should invest in index funds and buy and hold, the correct answer would probably come as a huge surprise: none at all!

This is actually a common situation encountered by many investors, particularly investors who like to buy stocks and believe that owning individual companies offers greater diversification.

It Takes Time

However, stock ownership isn't a get-rich-quick scheme. The stock market takes time to grow. And it takes time to generate profits.

In other words, if you were to ask an investor who should buy and hold which type of stock, they'd probably come up with several answers, including large-cap, mid-cap, small-cap, small, and international.

But it's safe to say that no one would come up with the answer “indexes”.

And so many individual investors do index because they're lazy. Indexing is a technique whereby the investor invests in an index, the S&P 500 for example.

An index fund is a mutual fund that invests in an index. Buying and holding a mutual fund is simple, but not the best way to do diversification.

Index funds aren't the best way to get diversified

Purchase Index Funds

The most diversified way to invest is to diversify into indexes. Many investors purchase index funds and then invest in each individual stock in the index.

What index investor is likely to tell you he or she is not getting any bigger profits than two per cent? (This is a huge understatement!).

The biggest problem with this approach is that many individual investors are making less than two per cent on their stock purchases.

How can you expect to make 20 per cent in just a few years if you are only getting 1 to 2 per cent returns?

Diversification

The answer lies in diversification. Without diversification, an investor can expect to make just a couple of per cent on one or two investments, which obviously is not enough to live on. Even if you do make 20 per cent on just one stock, you are still only diversifying about ten per cent of your portfolio.

This means that you can't expect to make very large returns on your portfolio. In fact, if you hold ten stocks that average about a hundred thousand dollars, you are only diversifying about a thousand dollars!

A better approach is to diversify into indexes. An index investor can expect to make three to five per cent on each index investment.

Winner

With ten index investments, he or she can expect to make a thousand to five hundred thousand dollars in profits. The most diversified investor is the winner!

Index funds are not the best way to go long term. A great strategy for investing is to have a portfolio of market index funds.

Have a few long term stocks and a few short term stocks. Never diversify out of either end of the market. Let the market do the investing for you.

This keeps you from sinking into a pit of failure.

This is an area that you will have to decide for yourself. I hope you found the post How To Create An Index Fund helpful, If so you might find some of my other posts below of interest. Thanks for stoping by.