Investing In Index Funds - What You Need To Know

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You can spend countless hours searching for stocks that might ‘beat the market’, or even investigating the financial records of numerous companies to determine if they are high or low risk.  However, if you’ve been researching a way to invest without the stress and never-ending effort, you may have already discovered that you have another option.  

Out of the many investment options that are out there, index funds are an excellent choice for most investors. Read on as we explain why. 

This article will help you understand the following:

  • What Index Funds Are
  • The Different Types of Index Funds
  • The Pros and Cons of Investing in Index Funds
  • Whether They’re The Right Investment For You

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What is an Index Fund?

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An index fund is a collection of stocks representing a particular market or segment of the stock market. When you invest in an index fund, you’re investing in all the companies that make up that market. 

When it comes to investing in shares, two types of share options come up time and time again: Actively Managed Funds and Index Funds. Actively Managed Funds, also known as mutual funds, operate by employing stock pickers to choose the companies the fund invests in with the goal of beating that particular market’s performance. Index Funds operate very differently.

In fact, Index Funds are an investment type that follows the performance of a particular  index, or curated selection, of stocks and shares. Index Funds are made up of the same stocks that are part of the index – often a prominent, well-performing index of shares maintained by a respected third party. This is usually inclusive of hundreds of companies in a particular market segment, for example, meaning an index fund has built-in diversification, and its success is built around the performance of the entire segment, rather than just individual companies.

The result:

Index funds are an option that is low in management fees due to being passively managed. It is relatively easy for the average investor to get started, both requiring a lower amount of cash to invest, and without the need for intensive research to select individual stocks.  

The aim of index funds is simple: to give everyday families a chance to gain a solid portfolio of proven-to-be-profitable shares without having to spend a significant amount of time managing their portfolio or spending thousands on fund management fees.

Instead, all you have to do is pay an index fund intermediary a small, built-in fee in exchange for that intermediary spreading your cash across the market.

Warren Buffett, famed investor and champion of this type of investment, puts it best:

“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

Interested in learning more about how index funds can help you kick-start your portfolio?  Our financial advisors work with you to create an investment plan suited to your situation that works to achieve your goals. There is never a better time to start than today!

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How Do Index Funds Work?

John Bogle, founder of the Vanguard Group, invented the Index Fund in 1975. This new idea took what was previously a complex and relatively inaccessible universe of shares and reduced it to a simple, singular entity.

Bogle identified a problem within the investment system. Share portfolios had become exclusive to investors with a wealth of financial knowledge, time to spare, and cash to burn in risky behaviour that threatened the stability of the entire market. This left the average person boxed out of owning a share portfolio, as they didn’t have access to the same information on  ‘good investments’ and didn’t have money to spare on managerial fees.

So, Bogle set out to try something different. Instead of trying to outperform the market in pursuit of potential greater returns, as was the goal of actively managed portfolios, the index fund would simply replicate an index that already had a reputation for providing steady returns.

The most famous example of this index replicates the Dow Jones Industrial Average Index. The Dow Jones Index is a list of stocks from 30 blue-chip companies in the United States which are important to the economy of the country. This index is weighted by stock price and makes adjustments for things such as stock splits when necessary. An index fund replicating the Dow Jones Index then follows the behaviour of the index itself as it aims to emulate the highs and lows of the index.

Index Funds have low fees because they don’t employ highly paid fund managers to pick shares. Since there is less work involved in managing an index fund, the fees associated with that fund are naturally much lower. And when there are less fees involved, it means more cash to put into your pocket or re-invest as you grow your portfolio.

By creating this investment option, Bogle opened up the share market to the average person by providing a way for you to create a profitable portfolio without having to invest a significant amount of cash or pay high management fees.

The Different Types of Index Funds

Exchange Traded Funds (ETFs)

Exchange-traded funds, otherwise known as ETFs or leveraged funds, are a type of index fund that combines the benefits of managed funds with the low fees of index funds.

ETFs provide direct exposure to a broad variety of options in their chosen asset class, usually including a mix of Australian shares, international shares, and bonds.

Like all indexes, ETFs are created using an indexing approach wherein your individual investment is pooled with other investors’ money in order to allow you to gain access to a wider range of assets than you could purchase on your own.

And since ETFs track a market index, rather than guessing which individual companies will perform well, the management fees associated with this type of fund are significantly lower than the managed alternatives.

The structure of ETFs can also be broken down into two approaches, depending on the method of the fund manager. These approaches include:

Full Replication

A Full Replication ETF involves buying and holding every security in the index the fund is replicating in exactly the same weighting.

This type of approach is common for investments tracking large and liquid indexes, such as the S&P 500 or Russell 3000. By holding every security in the index, this type of fund aims to replicate the success of the model index with as much accuracy as possible by essentially becoming a copycat of the original index.

But the smaller the fund is, the more difficult or impractical it becomes to replicate the original index to this degree, as some stocks can be incredibly expensive. It is also difficult to create a full replication ETF for extremely large indexes for the same reason.

So, in order to get around this problem for extremely small or large indexes, ETF fund managers utilise a strategy known as optimisation.

Optimisation

Optimisation, also known as sampling, in relation to ETFs means buying the securities in an index that provides the most representative sample of the index based on risk, exposure, and correlations between individual shares.

A sampling strategy lowers costs for investors by cherry-picking shares but runs the risk of creating a more unstable environment by reducing the asset diversity of the fund. Fund managers of optimized funds also often have to decide if the cost of acquiring the asset is worth overwhelming the tracking benefit of owning that asset.

To put it simply: optimisation often involves some educated guesswork when it comes to constructing the fund in exchange for significantly lower costs to investors than a full replication fund.

Enhanced Index Funds (EIF)

An enhanced index fund is a type of fund that aims to enhance the returns of a model index by utilising active management to modify the weights of holdings for additional return.

Most EIFs rely on active management methods based around a specific index in order to generate a modestly improved return on traditional indexes, which are mostly passive in their methodologies.

Similar to ETFs, they combine the best of both worlds of both passive and actively managed investment options by offering low operating costs and higher diversification.

EIFs differ from traditional actively managed assets as they can’t deviate too much from the index they’re tracking and still feature low fees and low turnover. 

However, enhanced index funds are still essentially ‘actively-managed’, which means that potential investors should consider the introduction of management risk in addition to market risk.

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What are the Benefits and Downsides?

While there are a number of different types of index options, all share common features that have both pros and cons.

Benefit: Fees Are Significantly Lower

We said it before, and we’ll say it again: indexes provide one of the most accessible opportunities for investment for the everyday family. A large part of this accessibility comes from the lower management fees than other types of assets in shares. Since the index fund focuses on tracking assets that have already proven their performance, there is less work involved in managing which shares should be bought and sold—the result: is less management fees and a higher return for the average investor.

Benefit: Index Funds Are Inherently Diverse

Here’s another reason to invest in index funds. At My Wealth Solutions, we believe that a successful investment portfolio is a diverse investment portfolio. A diverse portfolio allows you to minimise the risks associated with investing as you spread your assets across multiple sectors and industries.

Tony Robbins, motivational speaker and investment guru, agrees that diversifying your portfolio is crucial and that indexes are a great way to do this.

Indexes are inherently diverse as they track indexes that contain shares across a spectrum of different companies and even sectors. It could be expensive for the average investor to accumulate these same shares individually, meaning that the solo investor usually ends up with a significantly less diverse portfolio (depending on their investment capital). By investing in indexes, this problem is eliminated as you gain access to a diverse portfolio for a fraction of the price of purchasing the same assets individually.

Downside: Little Opportunity For Outperforming

While your appetite for risk will play an important part in exactly what type of investment strategy is right for you, indexes tend to be favoured by those seeking a stable investment with steady growth.

While the difficulty in achieving constant returns over the long term means that it’s rarely possible to outperform the market overall, indexes remove this possibility altogether. Since indexes are focused on tracking and replicating an index, there is no opportunity to attempt to outperform the performance of the model index.

Downside: A Lack Of Clarity

Due to the inherent diversity of index funds, it can be much more difficult for the index fund investor to determine at a glance exactly what assets they own than if they had selected the assets themselves.

This becomes especially important for those looking to incorporate corporate responsibility or ethical investing into their investment strategy. By investing in an index fund, you have little choice over exactly which shares your money is being invested into.

Are Index Funds the Right Option For You?

Indexes are an investment option that provides a way to grow your wealth without having to sacrifice a portion of your returns on management fees. But just like any investment option, the answer to the question of whether investing in index funds is right for you will depend on your financial circumstances and goals.

But you don’t have to figure out your investing strategy on your own. We’re here to help.

Our team of expert investment advisors can help you learn more about investing and index funds in the context of your personal situation and how investing can help you build your financial future.

Get in touch today to find out how we can help you achieve financial security..

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Guy Freeman - Managing Director

As a founding partner of My Wealth Solutions, Guy has a wide range of experience in all facets of finance and is passionate about providing practical advice, guidance and assistance. Guy has around 20 years of experience in holistic financial planning and wealth management, and has founded several of his own financial services businesses.

His qualifications include Diploma of Financial Planning, Advanced Diploma in Financial Planning, Self Managed Super Fund accreditation and a Bachelor of Biomedical Science.

Read more of Guy Freeman articles

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