What is an index fund and why would you consider using index funds in your investment portfolio?
What is an Index Fund?
An index fund is an investment fund that tracks a specified investment index and can be either a managed fund or an ETF
An index fund takes to stock picking out of investing.
Instead of buying an individual stock on the ASX (Australian Stock Exchange), you opt to buy a market index.
What is an Index?
Q How do you measure the performance of different stock markets around the world?
A You use an index to represent the performance of a basket of stocks in that stock market.
Index as a Benchmark
So an index is essentially a basket of stocks investors use as a performance benchmark.
Believe it or not, there are 24 commonly used indexes in Australia, that measure the performance of different parts of the market:
Example: ASX 200 Index
The most common measure of the performance of shares in Australia is the ASX 200 index
EXTRACT: ASX 200 Constituents
If you want to see how the Australian market has performed in the last 6 months, you simply look at the ASX 200 index performance:
Calculating Index Performance
On 9 August 2016 the index value was 5,543, whereas on the 9 February 2017 the index was valued at 5,720.
If you had of held an index over this period you would be up 3.2% (5,720 / 5543 = 1.0319 = 3.2%).
Mind you between late August and early December 2016 the index was under the 5,543 level and you would have been losing money on paper.
When Did Indexes Come About?
The first index in the world was the famous Dow Jones Index in the US, which was first calculated on 26 May 1986.
Dow Jones (the company) now records and produces over 130,000 different indexes for investors.
When Did it Become Possible to Invest in Indexes?
Believe it or not, index investing is only a relatively recent phenomenon and it took a while to catch on.
The first index fund (an index you can actually invest in) was developed by John Bogle and opened to investors on 31 December, 1975.
John Bogle’s company, Vanguard, has grown to become one of the largest managed fund companies in the world.
Not bad for a investment product which was described as ‘Bogle’s Folly’ when it was first introduced to investors.
How Can You Buy an Index?
There are two main ways to invest in indexes via:
Index managed funds
Exchange Traded index Funds (ETFs)
Both of these options will give you an investment exposure to the index, the only difference is how you execute.
With a managed fund you have to send an application form to the provider to buy and sell your investment.
With a Exchange Traded Fund, you can buy and sell your index fund ETF directly on the stock market (ETF’s are a fast growing part of the index fund industry).
Why Should You Consider Investing an Index?
Index fund investing has been increasing in popularity for two main reasons:
1. First they are generally low cost when compared with their main competitors managed fund.
For example, the price of Vanguard’s US Total Market ETF is 0.05%, which compares favorably with managed funds offering the same exposure where the fee is usually over 1% (some 20 times more expensive).
2. Second, index funds tend to perform better than actively managed funds.
Standard & Poors (the company that develops and tracks global investment indexes such as the S&P / ASX 200 index) regularly reviews the performance of managed funds to the benchmark index.
S&P SPIVA Research:
Over the years, the S&P research has shown that the majority of managed funds can’t beat their benchmark index.
For example, in Australia in the 5 years to 30 June 2016 only 3 out of every 10 managed funds (69.18%) beat their benchmark.
Read why Warren Buffett prefers index funds to actively managed funds below…
How Can I Incorporate Index Funds into my Portfolio?
It is now possible to build a solid portfolio using a combination of indexes alone.
In fact robo-advisers such as Acorns and Stockspot only use Exchange Traded Index Funds to build their investment portfolios.
Here are two ways you can incorporate index funds into your portfolio.
1. First, if you currently hold an actively managed fund, look to see if there is a similar index fund or ETF available and then consider switching to the index if it offers a better performance and or lower fees.
As we have explained, chances are the index fund will save you heaps in investment fees and also provide a better overall return (note consider the tax implications of selling your managed fund and the changeover costs).
2. Second, if you have spare cash look through the available index fund ETFs and see if there are any sectors or themes you would like to gain access to.
In many cases you may find that you can replace a number of your direct shareholdings, with ETFs which will not only reduce single stock risk, but will also cut your brokerage charges as you will have to rebalance your less often (compared to direct share holdings).
- Index funds provide mechanical exposure to an index, as opposed to an actively managed portfolio fo shares
- Index funds allow you to take the stock picking out of investing
- ETF’s provide an easy way to gain exposure to indexes and themes for a very low cost
- Warren Buffett recommends index funds (which you can access via ETFs)
The information on this blog and website is of a general nature only. It does not take into account your individual financial situation, objectives or needs. You should consider your own financial position and requirements before making a decision. We recommend you consult a licensed financial adviser in order to assist you with this.