Earn Passive Income by using Index Funds

passive income index fundsPassive income is defined as income which is obtained by applying a “hands-off” approach, where minimum or no work is required to manage the assets that produce the income. The main benefit of having sources of passive income is that you can use time, the most precious commodity, to engage in other enjoyable pursuits or for generating income in other ways instead of focusing on one activity only.

Index Funds Investing

I am developing other methods of generating passive income but my preferred way is by using Index Funds. An Index fund is an investment fund that aims to track the performance of a particular stock market, for example the FTSE 100, S&P 500 or Nikkei 225.For UK investors, index funds can be held in an ISA (Individual Savings Account). A detailed guide for opening an ISA is provided here.

Index funds are passively managed and do not aim to “beat the market” as opposed to actively management funds which have objectives of outperforming the market. When you buy an index fund you buy actual portions of the companies held within the fund so it is important to think like an owner. Picking individual companies is out of the question due to the risk caused by lack of diversification.

The main benefit of index funds is that they are less costly to own than actively managed funds due to absence of the high trading costs, frictional costs and excessive management fees charged by fund managers. Index funds have also been proven to perform better than actively managed funds in the long term.

Warren Buffett on Index Funds

Warren Buffett, the greatest investor of all time, recommended that most people will do well if they invest in a portfolio of passively managed index funds. In the 2013 Berkshire Hathaway annual letter to Shareholders on page 20, Buffett says the following with regards to his estate:

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”

“The Bet”

In 2007, Warren Buffett made a $1 million bet that over 10 years, an index fund based on the US S&P 500 would perform better than actively managed hedge funds. The bet is administered by Longbets.org and its details can be found here. He provides a commentary on the background of the wager in the 2016 letter to Berkshire Shareholders on page 22:

“Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers – who could include their own fund as one of the five – to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?”

Buffett has been winning the bet so far. Nearly 10 years in, the Wall Street Journal video below reflects on the latest numbers.

Example Index funds

Below are good examples of index funds that could be used by a UK based investor.

UK Index funds – Data is accurate as of February 2017. Currency used is GBP.
FundAnnual feesYield5 Year Annual Performance
Vanguard FTSE U.K. All Share Index Unit Trust0.08%3.33%9.19%
Vanguard US Equity Index0.10%1.34%18.64%
Vanguard Japan Stock Index0.23%1.58%11.99%
Vanguard U.K. Government Bond Index0.15%1.67%4.45%

As you can see, considering only the dividend yield provided, the return on these index funds would have been greater than that from cash savings accounts over the last 5 years, especially taking into account the prevailing historically low interest rates. Over the long term, investors are expected to do well as long as they keep costs low and minimise trading.

You will have noted that I only use Vanguard index funds. This is because Vanguard operate a unique structure where investors in their funds are also mutual owners of the company. Therefore, I believe that the company has the best interests of investors in mind.

Focus on costs

Vanguard also tend to have the lowest cost funds in the industry and the company were among the pioneers of the index fund in the 1970s. I also admire the founder of the company, John C. Bogle, and invest by his principles. I strongly recommend the following book by Bogle. You can click on the link/ image to purchase the book from Amazon.

The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. John C. Bogle.

All you need to know about index investing in a concise, compact and easy to read package. Other valuable book recommendations and reviews are available on the resources page.

Portfolio withdrawal – 4% rule

Once you have built up a diversified portfolio of a reasonable size, you will be able to withdraw up to 4% of it with a very low probability of depleting the funds over a period of over 30 years. The use of this safe withdrawal rate has been proven by different research findings including the 1998 Trinity Study, an influential paper by 3 Trinity University professors, upon which the 4% rule is based.

How much do you need to retire early

To hit the early retirement figure, you need to ensure that your portfolio is large enough such that a 4% withdrawal or income from it can cover your annual expenses. The formula to use is as follows:

Financial Independence Portfolio = 100/4 x Annual Expenses

This is not a get rich quick scheme. From my experience, it requires dedication, discipline and many years to accomplish. Put in the hard work now and reap the benefits later.

If you set goals, spend smartly, maintain a high savings rate and invest all this will be possible.

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