Index funds & (compound) interest / how they build up over time?

[Mrblobby]

Hello.

New here (and to the investment thing), with a question that will surely expose me as such!

I'm having trouble getting my head around some aspects of index funds and how they grow.
Let's say, for example, the popular eMaxi Slim all country (or similar).

Is 'compound interest' a thing with these things?
There doesn't seem to be any dividends paid, so how does that all work out?
I'm just curious as to how the wealth builds over the years, presuming I leave my money in there for 10,20,+ years.

I'm not a dummy (well, I don't think), but please treat me as one so I can understand!

Thank you.

And thanks for all the info I have learnt from this place.

[Tkydon]

See what I wrote about Compound Interest in this other thread

viewtopic.php?p=26616#p26616

[Mrblobby]

Hello Tkydon

Thank you for your reply.

I had actually read your post earlier today... but, unfortunately, I got a lost in too many words that don't mean a that much to me.

Might there be a somewhat simplified version (for dummies like me)?

[Tkydon]

Hello.

New here (and to the investment thing), with a question that will surely expose me as such!

I'm having trouble getting my head around some aspects of index funds and how they grow.
Let's say, for example, the popular eMaxi Slim all country (or similar).

To answer you specific questions:

An Index Fund is a Mutual Fund that aims to produce the same return as an Index by buying the stocks used to calculate the Index in the proportion they are reflected in the Index.

If we take the Dow Jones 30 Industrials, DJ calculates the Index Value every day based on the Prices of the Stocks in the Index on that day, but DJ doesn't own anything.

Now a Fund Manager wants to provide an Index Fund on the DJIA, and so buys the 30 stocks represented in the Index.

When you place your order to buy Units in their Fund, they take your money and buy the number of shares, or fractions thereof, of each of the 30 stocks at their current Prices in proportion to the Index to bundle together into the Units you buy.

When you place your order to sell, they sell the number of shares, or fractions thereof, of each of the 30 stocks at their current Prices equivalent to the Units you sell, and then give you your money when all the trades have cleared.

Each of the stocks in the DJIA pays a dividend, but not to you, to the Fund Manager.

Some funds pass the dividends through to the Investor, in which case you receive cash and pay tax on the dividend.

Others do not pass the dividends through, and instead, the fund manager then pays taxes and reinvests those dividends by buying more of the shares of each stock, and the value of your Index Fund Units goes up accordingly.

As the stock prices of the shares in the fund go up or down, the total Value of the Assets Under Management of the Fund goes up or down, and as you own a fixed number of units, your share of the total Value of the Assets Under Management divided by the total number of Units Issued or the Unit Price, multiplied by the total number of Units you own represents the value of your holding.

For Index Funds that pay out dividends, you pay income tax on the dividends, and you pay Capital Gains Tax when you sell on the difference between the buy price and the sell price, but the growth won't be so high as some of the money was paid out in dividends.

For Index Funds that do not pay out dividends, you don't receive any dividends, so there is no dividend tax to pay, only Capital Gains Tax when you sell on the difference between the buy price and the sell price, but the growth will be higher as all of the money was reinvested back in to the Units.

The eMAXIS-Slim is just a bigger bucket with a lot more stocks across the world...

Is 'compound interest' a thing with these things?
There doesn't seem to be any dividends paid, so how does that all work out?
I'm just curious as to how the wealth builds over the years, presuming I leave my money in there for 10,20,+ years.

I'm not a dummy (well, I don't think), but please treat me as one so I can understand!

Thank you.

And thanks for all the info I have learnt from this place.

See my other thread.

Bond Funds will have some element of compounding interest, called coupons, but the return of a Fund is usually backward looking to quantify the growth until now, and is only a guesstimate of how the Fund might perform (or not) in the future.

People say that you can 'expect' a return of maybe 7% to 10% on Equity based Funds in the future, but this is not an Interest Rate, and not guaranteed in any way. It is only a guesstimate based usually on some past performance, calculated looking backwards from some point in the future...

[captainspoke]

...
Is 'compound interest' a thing with these things?
There doesn't seem to be any dividends paid, so how does that all work out?
...

Maybe instead of using the commonly used term 'interest', like for a bank account, think of it as an increase in price/value (or 'return') over the years.

Percentages are typically used, like when you read "That eMaxis slim fund returned 10% last year". It's not that interest was paid (and you got 10% in cash), it's that the value/price of the shares you own has gone up by that much. Maybe you put¥100 in it last year, and now those same shares are worth ¥110. You could sell, but usually you just sit on it, and perhaps over the months and years keep adding to it.

Yes, there are some dividends paid, but here in japan many funds feed those back into your shares automatically--you don't even have to think about it, or do anything. (in some accounts, some situations, you can have the dividends paid out--e.g., a retiree might want some money to live on)

http://www.moneychimp.com/calculator/co ... ulator.htm

That's a simple calculator to play with (ignore that it's in dollars, just put in some numbers). Start with zero, add 10,000 every year for 25 years, at 6% (compounded annually, additions at the end of each period) and you'll have 548,645 at the end. Add a zero and you'll see the effect of regular saving/investing, and compounding--100,000 a year will result in something like 5,486,455 after 25 years. Double the contribution to 200,000 and it would be close to 11,000,000.

[Mrblobby]

Hello

Thank you very much for that! I’m getting there.

This is the bit that I have further questions on:

Others do not pass the dividends through, and instead, the fund manager then pays taxes and reinvests those dividends by buying more of the shares of each stock, and the value of your Index Fund Units goes up accordingly.

Might be a very stupid question, but…. In this case how exactly does the value of what I own go up?
Can that bit be elaborate on?

Appreciate the hand holding!

[sutebayashi]

If you were putting on a term deposit with a bank, with instructions that the interest paid be automatically reinvested with the principal, your say 10,000 might have become 10,500. Then your 10,500 gets put into a new term deposit and the whole cycle starts again.

It’s a similar thing with investments, which pay dividends rather than pay interest.

But, not all stocks pay dividends. Some prefer not to pay dividends and aim to grow the value of the company, rather than make regular payouts to investors. But where dividends are paid, they can be reinvested in the fund, rather than paid out.

With a term deposit, you might have an instruction to pay out the interest, rather than reinvest it. That would be similar to holding an investment that doesn’t retain its earnings, but pays out to the investor. (The value of a unit of this type of investment will not increase to the extent it would had it retained its earnings, all else equal)

[Tkydon]

Hello

Thank you very much for that! I’m getting there.

This is the bit that I have further questions on:

Others do not pass the dividends through, and instead, the fund manager then pays taxes and reinvests those dividends by buying more of the shares of each stock, and the value of your Index Fund Units goes up accordingly.

Might be a very stupid question, but…. In this case how exactly does the value of what I own go up?
Can that bit be elaborate on?

Appreciate the hand holding!

Just for illustration, and I may have made some mistakes, but...

At some point in time, say today, New Fund has X Billion in Assets Under Management, and in our DJIA example above, invests the total X Billion in the shares of the DJIA, so let's just say it's on a Value Basis, they own X Billion / 30 of each of the 30 stocks in the Index...
There are a certain number of Units issued, say X Billion Units, so each Unit is worth a Unit Price of 1. (X Billion / X Billion Units)

If more investors invest in the Fund on the same day, say monthly pension savings, the fund takes the incoming cash, Y, and buys additional shares, so now the Assets Under Management has grown to X Billion + Y, and the value of each share holding owned by the fund is now X Billion / 30 + Y / 30 of each of the 30 stocks in the Index... So the Fund issues those additional Units and each Unit is worth a Unit Price of 1. ((X Billion + Y) / (X Billion + Y Units). No change in Unit Price because the number of Units was increased to match the increase in Funds Under Management.

Now, if the Stocks pay dividends, say 5%, to the Fund Manager, and they retain and reinvest those funds internally, they go out and buy the additional Stock and put it into the fund. The value of each Stock Holding is now X Billion / 30 + Y / 30 + (X Billion / 30 + Y / 30) x 0.05 = (1.05X Billion + 1.05Y)/30 = 1.05(X Billion + Y) / 30
and the total value of Assets Under Management is now 1.05(X Billion + Y)
But the number of Units stays the same, so the value of each Unit has gone up by 5% to 1.05. (1.05(X Billion + Y) / (X Billion + Y Units))

Now, if the price of the Stocks goes up by say 10%, the number of Units stays the same, and the number of the shares owned by the fund stays the same, but the value of each share holding and of each Unit has gone up by 10% to 1.155...

Now the Fund Manager takes his Management Fee of say 1% per year, or 0.01155, so the value of each Unit has gone down by 1% to 1.14345.


The value of the initial units you purchased has gone up from 1 to 1.14345, or 14.345% increase.
You can buy new Units at this new price of 1.14345 to add to your portfolio...


Now, if new money comes in, Z, they have to buy shares at these new share prices 10% higher than the initial price, so the units are also priced at this higher price. So the Fund issues those additional Units and each Unit is worth a Unit Price of 1.14345. The Total Assets Under Management has grown to 1.05(X Billion + Y) + Z
No change in Unit Price because the number of Units was increased to match the increase in Funds Under Management. Unit Price of 1.14345

Now, if the Stocks pay dividends, say 5%, to the Fund Manager, and they retain and reinvest those funds internally, they go out and buy the additional Stock and put it into the fund. The value of each Stock Holding is now 1.05(1.05(X Billion + Y) + Z) /30
and the total value of Assets Under Management is now 1.05(1.05(X Billion + Y) + Z)
But the number of Units stays the same, X Billion + Y + Z Units, so the value of each Unit has gone up by 5% to 1.2.

Now, if the price of the Stocks goes up by say 10%, the number of Units stays the same, and the number of the shares owned by the fund stays the same, but the value of each share holding and of each Unit has gone up by 10% to 1.32...

Now the Fund Manager takes his Management Fee of say 1% per year, or 0.0132, so the value of each Unit has gone down by 1% to 1.3068.

The value of the initial units you purchased has gone up from 1 to 1.3068, or about 30% increase, over 2 years, so the growth per year was SQRT (1.3068 / 1) - 1 = ((1.3068 / 1)^(1/2)) - 1 = 14.315% per year...
You can buy new Units at this new price of 1.3068 to add to your portfolio...

And so on...


This is extremely simplified for illustration purposes only, and I'm sure I've made some mistakes...

Stock prices change by the second, and Units are priced on a daily basis at the end of every trading day.
Index Funds can track hundreds of stocks in different currencies, with different growth rates and dividend payouts, the order of events, and so on...

[TokyoBoglehead]

Hello

Thank you very much for that! I’m getting there.

This is the bit that I have further questions on:

Others do not pass the dividends through, and instead, the fund manager then pays taxes and reinvests those dividends by buying more of the shares of each stock, and the value of your Index Fund Units goes up accordingly.

Might be a very stupid question, but…. In this case how exactly does the value of what I own go up?
Can that bit be elaborate on?

Appreciate the hand holding!

Just for illustration, and I may have made some mistakes, but...

At some point in time, say today, New Fund has X Billion in Assets Under Management, and in our DJIA example above, invests the total X Billion in the shares of the DJIA, so let's just say it's on a Value Basis, they own X Billion / 30 of each of the 30 stocks in the Index...
There are a certain number of Units issued, say X Billion Units, so each Unit is worth a Unit Price of 1. (X Billion / X Billion Units)

If more investors invest in the Fund on the same day, say monthly pension savings, the fund takes the incoming cash, Y, and buys additional shares, so now the Assets Under Management has grown to X Billion + Y, and the value of each share holding owned by the fund is now X Billion / 30 + Y / 30 of each of the 30 stocks in the Index... So the Fund issues those additional Units and each Unit is worth a Unit Price of 1. ((X Billion + Y) / (X Billion + Y Units). No change in Unit Price because the number of Units was increased to match the increase in Funds Under Management.

Now, if the Stocks pay dividends, say 5%, to the Fund Manager, and they retain and reinvest those funds internally, they go out and buy the additional Stock and put it into the fund. The value of each Stock Holding is now X Billion / 30 + Y / 30 + (X Billion / 30 + Y / 30) x 0.05 = (1.05X Billion + 1.05Y)/30 = 1.05(X Billion + Y) / 30
and the total value of Assets Under Management is now 1.05(X Billion + Y)
But the number of Units stays the same, so the value of each Unit has gone up by 5% to 1.05. (1.05(X Billion + Y) / (X Billion + Y Units))

Now, if the price of the Stocks goes up by say 10%, the number of Units stays the same, and the number of the shares owned by the fund stays the same, but the value of each share holding and of each Unit has gone up by 10% to 1.155...

Now the Fund Manager takes his Management Fee of say 1% per year, or 0.01155, so the value of each Unit has gone down by 1% to 1.14345.


The value of the initial units you purchased has gone up from 1 to 1.14345, or 14.345% increase.
You can buy new Units at this new price of 1.14345 to add to your portfolio...


Now, if new money comes in, Z, they have to buy shares at these new share prices 10% higher than the initial price, so the units are also priced at this higher price. So the Fund issues those additional Units and each Unit is worth a Unit Price of 1.14345. The Total Assets Under Management has grown to 1.05(X Billion + Y) + Z
No change in Unit Price because the number of Units was increased to match the increase in Funds Under Management. Unit Price of 1.14345

Now, if the Stocks pay dividends, say 5%, to the Fund Manager, and they retain and reinvest those funds internally, they go out and buy the additional Stock and put it into the fund. The value of each Stock Holding is now 1.05(1.05(X Billion + Y) + Z) /30
and the total value of Assets Under Management is now 1.05(1.05(X Billion + Y) + Z)
But the number of Units stays the same, X Billion + Y + Z Units, so the value of each Unit has gone up by 5% to 1.2.

Now, if the price of the Stocks goes up by say 10%, the number of Units stays the same, and the number of the shares owned by the fund stays the same, but the value of each share holding and of each Unit has gone up by 10% to 1.32...

Now the Fund Manager takes his Management Fee of say 1% per year, or 0.0132, so the value of each Unit has gone down by 1% to 1.3068.

The value of the initial units you purchased has gone up from 1 to 1.3068, or about 30% increase, over 2 years, so the growth per year was SQRT (1.3068 / 1) - 1 = ((1.3068 / 1)^(1/2)) - 1 = 14.315% per year...
You can buy new Units at this new price of 1.3068 to add to your portfolio...

And so on...


This is extremely simplified for illustration purposes only, and I'm sure I've made some mistakes...

Stock prices change by the second, and Units are priced on a daily basis at the end of every trading day.
Index Funds can track hundreds of stocks in different currencies, with different growth rates and dividend payouts, the order of events, and so on...

A great primer.

https://www.khanacademy.org/economics-f ... o-interest

[Mrblobby]

Thank you very much for the kind explanation.
That all makes sense.

I suppose my remaining question is (and perhaps let's take that e Maxis slim All country as an example, with no dividend):

At what point does this "the Fund Manager retains and reinvests those funds internally" happen?
When that does happen, am I aware of it (am I informed, etc?), or is it all in effect 'invisible' to me?

Thank you!