Index Funds: What Are They and How To Invest?

Investing

If you’re looking to start your investment journey or are just seeking more information on the types of investment options that are out there, it’s likely that you’ve heard of Index Funds.

When it comes to investing in shares, two types of share options come up time and time again: Actively Managed Funds and Index Funds. While 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 a little differently.

In fact, Index Funds are more of a concept that refers to a particular investment fund that attempts to replicate the performance of a given index, or curated selection, of stocks and shares. Index Funds work by choosing an already prominent, well-performing index of shares – usually maintained by a respected third party – then replicating that index by creating a new fund that owns every asset in that original index, or achieves the same end by purchasing similar assets in a different index.

The result:

An investment option that is low in management fees and relatively easy for the average investor to get started with a lower amount of cash to invest than the typical Actively Managed Fund.

The aim of index funds is simple: to give everyday families the chance to gain a solid investment 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 index funds, 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.”

This article will help you understand:

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To get started, first you’ll need to know how index funds can help you build a bright financial future in the context of your personal financial circumstances and goals. That’s where your personal financial advisor comes in as they work with you to create an investment plan that is suited to your particular financial needs and wants.

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What are Index Funds?

Invented by John Bogle in 1975, the founder of The Vanguard Group, the index fund took what was previously a complex and relatively inaccessible universe of shares and reduced it to a simple, singular entity.

Bogle saw a problem with the investment system wherein share portfolios had become exclusive to investors with a wealth of financial knowledge, time to spare and cash to burn in risky investment behaviour that threatened the stability of the entire market. Under this system, the average investor was effectively boxed out of owning a share portfolio as they didn’t have access to the knowledge of what made for good investment and lacked the money to pay for the fees the managers of actively managed funds charged.

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 funds, the index fund would simply replicate an index that already had a reputation for providing steady returns.

The most famous example of this is index funds which replicate the Dow Jones Industrial Average Index. The Dow Jones Index is a list of stocks from thirty 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 adjustment 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.

According to The Barefoot Investor, 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, as an index fund owns all of the investments in an index and as such doesn’t have to try and pick winners and losers, 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 invest again as you grow your portfolio.

By creating this type of investment option, Bogle opened up the share market to the average investor 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

Just like there a variety of indexes covering multiple countries and sectors, there are a number of different types of index funds that are commonly today. These include:

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 investments in their chosen asset class, usually including a mix of Australian shares, international shares and bonds.

Like all index funds, 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 investments 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 managed funds.

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 funds 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 is aiming to replicate the success of the model index with as much accuracy as possible by essentially becoming a copy-cat 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 provide 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 investment 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 index funds, which are mostly passive in their methodologies.

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

EIFs differ from actively managed funds as they can’t deviate too much from the index they’re tracking and still feature low fees and low turnover. Actively managed funds – on the other hand – are free to invest in anything they’d like and usually include higher manager risk, higher fees and higher turnover.

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

What are the benefits and downsides?

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

Pro: Fees Are Significantly Lower

We said it before and we’ll say it again: index funds 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 investments in shares.

Index funds are designed to track a collection of assets that usually have already proven their performance. Since the fund focuses on tracking these assets, there is less work involved in managing which shares should be bought and sold. The result: less management fees and a higher return for the average investor.

Pro: Index Funds Are Inherently Diverse

At My Wealth Solutions, we believe that a successful investment portfolio is a diverse investment portfolio. A diverse investment portfolio allows you to minimise risks associated with investing as you spread your assets across multiple sectors and industries and grow your wealth in a way that is right for your long-term goals.

Tony Robbins, motivational speaker and investment guru, also claims that diversifying your investment portfolio is crucial and that index funds are a great way to do this.

Index funds are inherently diverse as they track and replicate an index that will usually contain shares across a variety of sectors. It can be expensive for the average investor to accumulate these same shares on their own, meaning that the solo investor could end up with a significantly less diverse portfolio depending on their investment capital. By investing in index funds, this problem is eliminated as you gain access to a diverse portfolio for a fraction of the price of purchasing the same assets individually.

Con: 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, index funds 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, index funds remove this possibility altogether. Since index funds are focused on tracking and replicating an index, there is no opportunity to attempt to outperform the performance of the model index.

Con: 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?

Index funds 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 don’t worry – you won’t have to decide this on your own. We’re here to help.

Our team of expert investment advisors can help you learn more about index funds in the context of your personal financial world and how they could help you achieve financial security and success.

All you have to do is let us know how we can help.

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