07:52 AM, 24 Feb 2017 (AUS EST)   The market is currently closed       

Introduction to Index Funds

If you are searching for an index fund, it might be because you are sick and tired of paying your managed fund manager for the privilege of losing money. Index funds may not be as popular or sexy as managed funds, perhaps because of the record growth of the Australian share market in recent years or partly because index managers don't pay commissions to advisers, but they are fast growing in popularity.

Enter index funds. Index funds is a type of managed fund, but unlike traditional managed fund where fund manager hand picks the stocks, index funds don’t aim to beat the market, rather, to follow the overall trend of the market.

How index fund works

Compared to managed funds, index funds are a lot simpler to understand. Basically an index fund works by buying all the securities that make up a specific index, for example the S&P/ASX 200 index. How much of your money is invested in each security is dependant on the capitalisation of each company -  if the constituents of the index are the largest by market capitalisation, their movements will have a greater weighting, therefore aligning it with movements in the market. For example if BHP makes up 13% of the tracked index, then it will also make up the same portion,13%, of the fund.

The attraction of index fund over a managed fund is that they can replicate an index at much lower overheads. Fees from index funds can be as low as 0.35%, compared to an average of about 2% for managed funds. 

For example

Let's say we have 2 companies: Managed Fund ABC and Index Fund XYZ both returning 10% (the same as the S&P/ASX 200) for a particular given year. Managed Fund ABC charges 2% in fees, whilst Index Fund XYZ charges 0.75%. The returns for each fund are8% and 9.25% respectively (minus fees). After taking fees into account, Index Fund XYZ has a 1.25% greater return rate, and if we consider this over a 20 year period, the difference will be significant.

Index funds fees

Index funds are typically left to run themselves (granted a company must administer the costs of managing the back end of your investment – sending out statements etc). This type of investing style is called "passive investing" compared with traditional managed funds where a team of analysis help pick the stocks, this is called "active investing". Typically, index funds attract half the Management Expense Ratios (MER) than managed funds. The Vanguard Index funds only charge 0.75% p.a. and 0.35% p.a. for anything over A$100,000. Why are they cheap? They don't need to employ highly paid fund managers to help pick the shares, instead they just invest in all the securities that makes up the tracked index

A popular index fund in Australia is the Vanguard Index Australian Share Fund . The fund’s aim is to match the total return of the S&P/ASX 300 index.

Index fund Pros

  • Lower fees - Since an index funds primary goal is to follow a particular index, it doesn't require a team of managers to help pick stock, this is the reason why fees are considerably lower.
  • Simple - Index funds are easier to understand. Securities are bought to mirror a particular index (ASX50, ASX200, ASX300).
  • Lower turnover - The turnover rate is the frequency at which securities are bought and sold. Obviously the more transactions you make the higher the fees. If securities are bought and sold frequently, investors will pay more capital gains tax. Index funds generally have a much lower turn over rate.
  • Diversification benefits - For as little as $500, you can own every company within the ASX200.

Index fund Cons

  • Because an index fund tracks a specific index you will be investing in all the securities in that index even if you think a specific stock in that index is a bad investment. For example the tech boom of the 90s.
  • There is no chance that an index fund will significantly outperform a specific index.
  • Possible tracking drift.

Index Fund VS Managed Funds

Which should you choose? Which is better? The attraction of a managed fund is that they have they ability to outperform the market whereas an Index fund can only match it. You may be thinking why you should go with an index fund if it has no possibility of outperforming the market. Well although managed funds have the ability to beat the market, strong evidence shows that not many do (after factoring fees), and for those that do, not many can replicate those results consistently.

So it depends on the type of an investor you are. For those who have no exposure to financial markets and all you want to do is buy and leave, then an index fund is generally a better option. However, for those who are willing to do research, active managed funds are still a great option.