This article explains how Index funds work and tries to simply explain their benefits and disadvantages.
Index share funds typically have lower fees than active managed funds & you can rely on receiving capital growth and a dividend income return similar to the market as a whole.
Index funds are best suited to investors who recognise that shares outperform most other asset classes over the long term and want to allocate their share investments in a way that removes the chance of an incompetent active fund manager achieving a return less than the market average (eg: Australia’s ASX300 index).
Some comments on index funds follow:
In the 1996 Berkshire Hathaway Annual Report, legendary investor Warren Buffett wrote: “Most investors, both institutional and individual, will find that the best way to own common stocks (‘shares’) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.”
In his letter to shareholders in early 2008 Buffet repeated:
Naturally, everyone expects to be above average. And those helpers (bless their hearts!) will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average.
The reason is simple:
1) Investors, overall, will necessarily earn an average return, minus costs they incur;
2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low;
3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
“I know it’s hard to think about the next 20 years in the midst of a violent bout of sharemarket volatility and correction, but this is exactly the time when you must. That doesn’t mean you should just buy the index, although given the low fees of index funds and exchange traded funds, you could do worse. That would certainly be better than paying 2% fees for an actively managed fund that will be lucky to match the index anyway.”
– Alan Kohler in the “June 2006 ASX Investor Update email newsletter”
“index funds are worth considering. They match, mirror or mimic a sharemarket index. With a decade to invest, it makes the most sense as there is plenty of time to ride out the inevitable market corrections and maximise returns. The beauty of indexing is that there is no risk of picking a dud fund manager who may underperform the market and the fees for an index fund are much less than those charged by active managers”
– John Collett in the Age article “Build a future fund ”
When you invest “with” the market – whether through index funds, ETFs or Three Factor strategies – you start to focus on other aspects of investing that are important to having a successful investment experience, including: Keeping fees low, Keeping taxes low (our last active managed fund survey showed how much tax was paid from the high levels of income paid), Having a well diversified portfolio, Focusing on asset allocation as a key driver of returns.
A commentary on index-style investment options would not be complete without a few comments on their flaws. First, buying into an index fund means that you are buying into a portfolio with capital gains, which is not an ideal solution. And index funds, while having a lower level of trading compared to active managed funds, still have some level of trading as investors come and go from a fund – what we might describe as “liquidity trading”.
– Invest “with” the market By Scott Francis – Eureka Report October 15, 2007 edition
The Efficient Market Theory is fundamental to the creation of the index funds. The idea is that fund managers and stock analysts are constantly looking for securities that would out-perform the market. The competition is so effective that any new information about the fortune of a company will translate into movements of the stock price almost instantly. It is very difficult to tell ahead of time whether a certain stock will out-perform the market.
If one cannot beat the market, then the next best thing is to cover all bases: owning all of the securities, or a representative sampling of the securities available on the market. Thus the index fund concept is born.
Because the composition of a target index is a known quantity, it costs less to run an index fund. No stock analysts need to be hired.
In Australia the annual fee for most active retail managed share funds is around 2%. In comparison the annual fees for a retail passive index share fund are 0.5-0.8%.
As a specific example, the well regarded “Perpetual’s Investor Choice Funds – Australian Share Asset Group” charges a flat management fee of 1.95% p.a. (per annum/year) regardless of the amount invested.
In comparison the popular “Vanguard Index Australian Shares Fund” charges a management fee of 0.75% p.a. for the first $50,000 reducing further the more you invest eg: 0.50% p.a. For the next $50,000 and 0.35% p.a. for the balance over $100,000.
This means that given all else is equal the Perpetual fund needs to outperform the Vanguard fund by at least 1.2% to achieve the same return after fees.
ABC TV’s “Lateline Business” host Ali Moore interviewed chairman and CEO of the Vanguard group Jack Brennan about the managed funds industry on 17/10/2007:
Benefits of Index Funds
- Lower fees – Earnings from the stock market are unpredictable whether you invest in a passive index fund or an active managed fund. However fees arfixed and known from the start so investing in an index fund gives you a head start due to the inherantly lower fees (see Perpetual vs Vanguard comparison above)
- Less Volatility and Worry – because Returns and Dividends will roughly match the overall stock market (before fees). Regardless of whether the market is rising or falling you know that your investment is following the same trend and although you won’t earn much better than the index, on the flip side you won’t lose any more than the index either.
In comparision with an actively managed fund you may earn more than the market, but you’re equally likely to earn less if the manager of your actively managed fund makes bad decisions.
- Possible tax advantages – because index funds usually have less turnover than actively managed share funds
- Diversification Benefits – Active managers typically only hold a subset of securities that are contained in the index. Index funds, by their very nature, effectively hold the market which may have diversification benefits.
Disadvantages of Index Funds
- Index funds returns will track the market return. There is no possibility of outperforming the market as actively managed funds claim they can do.
- Index share funds are still inherantly risky over the short to medium term compared to cash investments and may fall in value if the overall market falls.
- Index funds generally hold shares in companies in similar proportions to the index. Therefore Index funds will have large exposures to industries that dominate the index eg: Resources or banks
Overall there are many benefits to investing in Index funds, In fact, 7 out of Australia’s top 10 super funds use indexing (Source: By FUM, Rainmaker and Vanguard)
Note: As with any other investment you should not put all your eggs in one basket. It’s far safer to diversify across different asset types and investment management companies to lower the risks. As an example it may be wise to hold a large “core” proportion of investments in index funds and individually invest in other asset types such as actively managed funds, property, bonds and cash.
Lastly, if you do decide to invest in Index funds, make sure you invest directly in your own name and not via a financial advisor because they add no value and will take part of your money in fees for filling in a few pieces of paper. The reason many financial advisors don’t like to recommend index funds is because they tend not to pay kickbacks/commissions to financial advisors who recommend them.
Disclaimer: The author had investments in both Perpetual actively managed funds and Vanguard passive index funds at the time this article was written.
This information is general in nature and not tailored to your situation. It is not financial advice. You should read and consider the Product Disclosure Statement of any investment fund before deciding whether to invest in it.