What are Index Funds? How to invest in Index Funds?

What are Index Funds? Are they any good? What are the alternatives?


What are Index Funds?

Just as the name suggest, Index Funds are investment funds that track an index. You always hear about the ASX 200 dropping by 1.4% or trading up 0.9%. The ASX 200 is an index that tracks the performance of the largest 200 listed companies in Australia. The index is weighted based on the size of the companies (read market cap). At the end of Dec 2015, the Big 4 banks accounted for around 30% of the ASX 200 Index. The ASX 200 Index is the most common way to think about the performance of the overall Australian stockmarket.

An index fund that tracks the ASX 200 will buy shares / invest in those 200 companies. The % allocation to each company within the Index Fund will be based on the index weighting.

With Index Funds, your best case scenario is to make the returns of the index. For example, when investing in an ASX 200 Index Fund, your target return is the returns of the overall Australian stockmarket.

Index Funds are usually cost effective. They also offer good diversification. Most indices include 100s of companies in them - like 200 companies in the ASX 200. This broad exposure provide Index Funds with instant diversification.


Why are Index Funds low cost?

Index Funds are low cost compared to Managed Funds. For example, the Vanguard Australia Shares Index Fund costs 0.18% management fee. The comparable Managed Fund from AMP - AMP Wholesale Australian Equity Value Fund, costs 0.77% fees. The Managed Fund is 4x more expensive!

Index Funds are cheaper because they are easier to operate. The investment decision is on autopilot. The fund tracks the index, no stock picking, analysis, etc.

Compared to a Managed Fund, they employ Fund Manages to pick stocks because they try to beat the market. These Fund Managers are expensive to hire!

The chart below shows the allocation to the top 10 companies held by the AMP fund compared to the companies' actual allocation in the index. For example, AMP's Fund Manager believes in Wesfarmers, allocating 5.16% of the fund to the company when it is only 3.31% of the Index.


Does low cost mean low returns?

In the ordinary world, more expensive services are generally better. The reverse seems to be true in the world of investment funds.

Year after year, the stats show that fund managers (within Managed Funds) trying to beat the index are beaten by the index after fees. The chart below shows the % of fund managers beaten by the index over a 5 year period. Across the 5 investment categories (asset classes), only fund managers investing in small caps consistently beat the index.

Fund Managers of Australian shares were beaten by the index 71% of the time. Fund Manager picking global shares are beaten 90% of the time!

Index Funds will also be beaten by the index since their best case scenario is the index return - then they charge a fee. Typically, Index Funds will only be beaten by the index by the amount of fees they charge - Index Funds are generally low fees.

If Index Fund fees are less than the returns (per year) that Fund Managers are beaten by the index, Index Funds should be a compelling investment option.

The chart below shows the average underperformance of Managed Funds per investment category over the last 5 years. This shows the average % returns per year that Fund Managers were beaten by the Index. This is positive in the case of Small Caps, since Fund Managers beat the index. Compare this to the management fee charged by Vanguard's Index Funds. In four-out-of-five investment categories, Vanguard Index Funds cost less than the average Managed Fund’s underperformance. For example, average International Shares Fund Manager was beaten by the index by 2.19% per year. This compares to Vanguard International Shares Index Fund management fee of 0.18%.


Can you invest in Index Funds?

There are three ways of investing in Index Funds:

1) Invest through your Financial Planner: you'll have to pay your planner a fee

2) Invest through your wrap platform: wrap platforms are generally expensive to run. They charge between 1% - 2% on money invested through the platform

3) Invest directly from the product company: Vanguard, Blackrock and BT all offer Index Funds to consumers. You can download their PDF and fill out the form. However, you need to invest a minimum of $500,000 per fund.

Vanguard does offer a bunch of Vanguard Retail Index Funds. Their Retail Funds have a minimum of $5,000 investment.

But, Retail Index Funds are a lot more expensive. The Vanguard Retail Australian Shares Index Fund costs 0.90% vs the comparable Vanguard Index Fund (wholesale) which costs 0.18%.


Your other option - ETF Index Funds

If you don’t have $500,000 per investment but still want to buy Index Funds, you can look to ETFs. Exchange Traded Funds (ETFs) are generally Index Funds that listed on the ASX. ETFs are large and lower cost to run. So they are often even cheaper than normal Index Funds.

In fact, Vanguard Australian Shares ETF (VAS) is actually the listed version of Vanguard’s wholesale Australian Index Fund. But VAS costs 0.15% in fees, cheaper than Vanguard Index Fund's 0.18% in fees.

Read about how to buy ETFs here

The disadvantage of an ETF is that you will incur a brokerage cost when you buy them through your online broker. Whilst Index Funds (retail or wholesale) can be purchased via BPAY, you don't have to pay any brokerage.

Read about the cheapest broker to buy ETFs here

About the Author


Cofounder & CEO of BetterWealth (@jeremykwonglaw). Former investment banker turned technology entrepreneur. muru-D alumni (Telstra startup accelerator). Passionated about leveraging technology to provide better financial products & services to consumers. Coffee snob, business book reader, and fitness fan.

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