The benefits of index funds

Index fund specialist Vanguard Australia’s most recent index chart tracks the 30 year performance of major asset class indices and demonstrates the strength of Australian shares. Robin Bowerman, Head of Market Strategy and Communications with Vanguard Australia, spoke with CANSTAR about what he sees as the benefit of holding index funds.

Q: What are the real benefits to consumers in holding index funds?

Index funds (both managed funds and ETFs) can offer investors a low cost and efficient way to capture the returns of a market or sub sector of a market.

Index funds are a great starting point when investors are putting together a portfolio because they capture the market return and there is a broad range of indices across a wide variety of asset classes.

So an index fund tracks a benchmark (or index) such as the S&P 300 Index which takes in the top 300 companies on the Australian stock exchange. They give investors greater diversification (and lower risk) at a much lower cost than if you invested in each share individually. When you invest in the index fund you have a beneficial holding in the underlying securities (300 shares in this example) and in the case of a share fund, that also entitles you to franking credits.
Index funds typically enjoy a head start when compared with actively managed funds because their operating and transaction costs are generally very low. Also, lower trading activity tends to make index funds more tax-efficient, because index funds typically generate smaller capital gains distributions than actively managed funds.

Index funds can provide a great core or base investment in a portfolio. If investors have real confidence that an active manager will outperform or they have a preference for a particular share investment then that can form the ?satellite? investments in the portfolio. This will ensure that the core of the portfolio will consistently deliver market returns.  Some investors who seek to outpace the market favour actively managed funds (or picking individual shares and trading frequently). However, actively managed funds and frequent share traders may also do worse than the market return—and they often do.  It is notoriously difficult to time entry and exits from markets consistently over time.

Q: There are so many different indices out there – how can investors know which indices they should focus on?

When assessing different index funds an investor should consider the manager?s longevity and track record.

Larger index fund managers can offer the benefit of economies of scale given the volume of assets they manage and often that will mean they can offer lower costs to investors.

If an investor is evaluating a few funds from different managers which are targeting the same asset class using different benchmarks an investor should look at some of the detail of the fund – you can often find this information on fund fact sheets which managers will have on their websites which will generally offer an overview of how many securities in the fund (demonstrating diversification), how much the annual management fee is and past performance. It may also discuss the style or how the fund is managed.

The key here is that an investor has a really good understanding of what they are going to invest in, if they don?t understand it, they should ask questions or potentially seek some advice from a good financial planner.

Q: Obviously investors should still look at diversification across assets classes, but if using an index approach, is there any need to diversify within asset classes (e.g. should investors hold two Australian share index funds, or is that over-diversification).

This really depends on the index funds you currently hold and your personal preferences and conviction in particular asset classes.  Vanguard believes strongly in broad, market cap weighted indexing for the foundation of the portfolio.

Investors can choose to invest in index funds that track sectors of markets – for example high yield or large and small cap Australian Shares – but investors need to be aware that they will then be taking an active bet on a particular factor. That is perfectly reasonable on the basis the investor understands that the returns will be different to the broader market.

An alternative approach is to invest in diversified index funds which some investment managers offer that combine a range of indexes to target a particular risk profile.

Vanguard has four diversified fund options which offer what we see is the optimal mix of assets for a conservative, balanced, growth or high growth portfolio. Within the balanced portfolio there is a 50:50 split of investment across income and growth components and includes allocations to Australian and International Shares, property and fixed income.

These diversified funds offer a simple, one-stop solution with the in-built bonus that they automatically rebalance the portfolio as markets move through different economic cycles.

The challenge for investors is to look beyond the headline performance of individual assets or shares and instead build a portfolio for all-seasons based on the right mix of fixed income, cash, property and shares that matches your personal risk tolerance and helps harness the power of diversification to help you stay the course over the long run.

Q: What makes you personally passionate about index investing?

The simplicity and the low cost. At the end of the day when investing, you get what you don?t pay for – you cannot control future performance but you can control costs.

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