It’s a pretty broad category, however, and there are a number of ways you could approach index fund investing, some of which may be more suitable than others, depending on your situation.
To help you narrow down your options and decide if an index fund is right for you, Canstar asked financial advisor Ben Brett, of Bounce Financial, to explain some of the ins and outs.
What is an index fund?
An index fund is an investment fund which, instead of trying to pick high-performing shares, has an investment philosophy that tries to invest broadly across the market. Each fund differs in how it goes about this, but loosely, its focus is on matching a particular ‘index’ such as the S&P/ASX 200, which is the 200 largest publicly-listed companies in Australia.
The goal of an index fund is to benefit from the increase in the share market as a whole, rather than hope that individual companies will go up in value.
Why invest in an index fund?
It is generally understood that you should diversify your investments. The problem with trying to diversify a share portfolio is that most people don’t have enough money to buy individual shares of enough companies to be adequately diversified.
To get around this, you have the option of buying into an investment fund, such as an index fund. An investment fund pools your money with other investors so that it can buy a diversified portfolio of shares on your behalf. Each fund has an investment philosophy on how it chooses to invest, which helps you know what you are investing in. For example, you may choose an investment fund which focuses on high performing technology companies or perhaps companies who act ethically. An index fund, however, focuses on investing across the whole market and generally doesn’t focus on particular sectors or types of companies.
As index funds are passively managed, i.e. they do not need investment experts to try and pick high performing shares, the fees are generally lower than actively-managed funds.
What index fund options are there for investors?
There are a couple of ways you can invest in an index fund. Each option suits different people based on their circumstances and their investment preferences.
Option 1: Managed fund
The first option is to buy into a fund made up of a pool of other investors whose investments are overseen by a manager who aims to follow an index. This is generally referred to as a ‘passively managed fund’. There are usually minimum balances you need to be able to invest directly in a managed fund, so this may suit people who have higher amounts to invest. A fund manager will generally charge a fee to invest your money and this is usually a certain percentage of how much you have invested.
Option 2: Exchange traded fund (ETF)
A lot of investment funds offer the ability for you to buy shares in the fund on the stock exchange. These exchange traded funds usually don’t have minimum investments thresholds that are as high as those of managed funds, so this can be a good option for those who have lower amounts to invest.
Like a managed fund, there is usually a fee to manage this investment which is reflected in the investment performance and is referred to as an ‘Indirect Cost Ratio (ICR)’. Unlike a managed fund, however, each time you buy and sell shares in the ETF, you will usually have to pay a ‘brokerage’ fee. This is the fee you pay to your share-trading platform for the cost of the share purchase or sale.
ETFs may suit people who have smaller, one-off amounts to invest.
Option 3: Investment platform
Another option is to invest through an investment platform. An investment platform, which is sometimes called a ‘wrap account’, allows you to invest in various managed funds with lower minimum balances. The platform will also provide you with consolidated reporting and may have cheaper fees for the investments within it. There is, however, usually an administrative fee for the platform on top of the investment fees.
Who might an index fund be suitable for?
There is no one right way to go about investing. While some people watch the share market daily and like to buy and sell shares regularly, others are looking for more passive ways to invest, freeing them up to focus on other aspects of their life.
An index fund may suit someone who wants a more “hands-off” approach to investing and is happy to contribute regularly, with the hope that the entire market will increase in value over time. There is a lot of dispute about whether an actively managed investment can even beat an index fund, but as we are talking about predicting the future, we will never truly have a definitive answer.
When might an index fund not be suitable?
Even if something is a great investment for others, if it doesn’t suit your goals and needs, it may be a bad investment for you.
You need to consider whether investing in shares is right for you at this point in your life. For anyone who has debt, such as credit card debt or a car loan, you may be better placed to pay off your debt instead of investing, for example.
You also need to consider your timeframe for investment. Most index funds are designed to be long-term investments and may need to be held for a number of years before they will offer any real value. This is because index funds, while generally more stable than individual stocks, can still be volatile investments, meaning they may go up and down in value daily. If you invest in an index fund with a short timeframe in mind, you may need to withdraw your money while the investment value is down, meaning you will lose money.
Finally, it’s always best to think about how much you have to invest, how much you plan to contribute (and how often) and how you plan to withdraw the money (either as a lump sum or in small amounts). All of these factors will determine your investment strategy.
An index fund is simply one of many tools available to you to build your investment strategy, so always start with your ‘why’.
How do you invest in an index fund? Six steps to success
Before considering any type of investing, it is best to build the foundations of your finances. This means setting up a sensible spending strategy and addressing any consumer debt you have, including car loans, credit cards and personal loans.
Once you are confident that you have solid foundations and can reliably save money, you may wish to consider how best to invest your money using these six steps.
Step 1: Get clear about your goals
Before investing, it is important that you be clear on the purpose of your investment. There is no one right investment, so your goals will dictate how you should invest. Conventional wisdom suggests the average investment cycle is seven years, which gives you an idea of the timeframes you should be looking to hold your investment. As a general rule, I try to avoid any investment in shares if the time period is less than three years.
Understanding how long you have to invest and what you want to spend the money on (i.e., how much money you will need in the end) will help you decide how to go about the next steps.
Step 2: Determine your contribution amounts and strategy
Do you intend to make a one-off investment or do you wish to contribute regularly to your investment? Making a one-off investment can introduce an additional element of risk, as the day you choose to purchase the shares may have an effect on the eventual outcome of their performance. If you do contribute over a period of time, you spread out this risk but potentially miss out on any returns from uninvested money. Depending on how you have chosen to invest (i.e. ETFs or managed funds), you may incur additional fees for either strategy.
Step 3: Determine your withdrawal goals and strategy
How do you intend to withdraw your investment and when? Is it the case that you are investing for a big-ticket item like a car or are you looking to supplement your income prior to retirement? Understanding your withdrawal plan before you start investing will help you to pick the right investment.
Step 4: Research investment funds
Now you have worked out your goals and contribution/withdrawal strategy, it is time to research investment funds. There are a large number of options out there so you’ll need to consider them based on fees, performance and investment philosophy.
If you are working with a financial adviser, they may be able to assist you by narrowing your search to investment funds which may suit your goals.
Step 5: Consider how best to buy the investment fund
Many investment funds have multiple options for how you can invest with them. We noted above the options of going direct to the fund, buying an ETF or investing through a platform.
Which one suits you will depend on how much you have to initially invest (as some have minimums), if you want to contribute regularly and whether you wish to withdraw your investment as a lump sum or in small portions.
If you have a smaller, one-off amount to invest that you intend to withdraw as a lump sum, then you may want to consider an ETF. If, however, you want to contribute regularly and/or withdraw over a period of time, you may wish to consider a managed fund or investing through an investment platform.
Step 6: Take action when you’re ready
If having done your research, sought advice if necessary, and chosen an index fund that matches your goals, it’s important to follow through on your plans.
The world of investing can be overwhelming, and I often see people give up and put it off time and time again.
If you are feeling overwhelmed, you may like to reach out to a financial adviser to help you take action. After all, your greatest asset when it comes to investing is time.
Cover image source: eamesBot (Shutterstock)