What are index funds?
What is indexing?
Simply, indexing is a way of gaining exposure to an investment market. Most investment markets have indexes that measure their value over time. For example, a share index measures the change in the value of the shares of the companies included in the index. Indexes cover almost every industry sector and asset class, including Australian and international shares, property, bonds and cash.
Indexes provide a way for fund managers to measure their performance. Usually, active fund managers will try to outperform the index, also called a benchmark, by picking the securities they believe will outperform in the future.
Index managers on the other hand, invest in all or a representative sample of the securities in the index and let markets do their work over the long term. Because index funds invest in all or most of the securities in an index, they provide diversification, which can mean lower risk.
What are the benefits of index funds?
Index funds are the most cost-effective way to get investment returns reflecting the returns of particular indexes. The main features of index investing are:
Lower fees: index funds are generally cheaper than actively managed funds (retail and wholesale) investing in similar assets. This is because they cost less to manage and operate.
Index funds also generally have lower portfolio turnover than most active funds which results in lower ongoing trading costs. Typically they cost around half the industry mean.
Long-term outlook: share index investing is based on the assumption that over the long-term shares outperform most other asset classes. In the short- to medium-term, share prices tend to fluctuate so index investing is about riding out the ups and downs.
Diversification: Index funds, by their very nature, effectively hold the market which means your portfolio may be better diversified than for example investing in individual shares or securities.
Key person risk: Active funds heavily rely on the skill of individual portfolio managers whereas Index Funds are more process dependent. By reducing the dependence on key individual, an index process delivers a greater certainty of ongoing outcomes and greater stability of results.
Simplicity: Index funds eliminate the difficult talk of continually trying to pick winners and outperform the market.
Are there any disadvantages of index funds?
- Potential loss of return: Index funds returns track market return so it's impossible to outperform the market as actively managed funds claim they can do.
- Short term risk: Index share funds are risky over the short to medium term compared to cash investments and may fall in value if the overall market falls.
How can index funds be used as part of an investment strategy?
One way is to use index funds as the core holding of a portfolio. You can then build on the core of broadly diversified index funds by selecting actively managed funds, or directly purchase in other assets such as shares or property.
Vanguard’s indexing approach
Vanguard believes a long-term approach to investing delivers the best results. That is why we buy and hold stocks with long-term growth in mind, rather than actively trading them in pursuit of short-term gains.
We look for the most efficient ways to manage our client's money. This means we manage costs wherever we can so you can keep more of the returns you earn.
Because we buy and hold stocks for the long term we have lower turnover than many active funds. Lower turnover means lower costs and tax, which can lead to better real returns for investors in the long run.
Our approach focuses on the end result - that is, the return you take home after expenses and tax. An example of this is the way we take advantage of capital gains discounts and the deferral of capital gains liabilities to minimize the tax impact for investors.
Not all index managers are the same. Instead of holding every security in an index, we aim to build portfolios with the optimal number of securities to closely track index performance without incurring unnecessary transaction costs. It's what we call optimizes indexing. This way investors get all the benefits of holding a diversified portfolio, like lower risk and enhanced return potential, without the associated costs.
