efficiency of index funds

28 May

5 Considerations Before Investing in an Index Fund

Posted at 09:40h

Index funds are a form of managed fund, but they are very different from the others. For reasons discussed below, the name ‘managed’ fund might be a misnomer. Index funds could be more accurately described as ‘administered,’ rather than managed. This is because the index fund manager tells investors exactly what it will do with money that they invest. The only management they provide is to act as a conduit between the investor and the share market.

What is an index fund?

An index is a number that represents the combined value of many different stocks for the purpose of ‘measuring the market’. Index funds cover a variety of industry sectors and asset classes including property, bonds, cash as well as Australian and International Shares. A commonly quoted index is the ‘All Ordinaries Index’ (AOI). The ASX website defines the AOI as follows:

“The index is made up of the weighted share prices of about 500 of the largest Australian companies. Established by ASX at 500 points in January 1980, it is the predominant measure of the overall performance of the Australian share-market. The companies are weighted according to their size in terms of market capitalization (total market value of a company’s shares).”

So, when a presenter on the nightly news says ‘the All Ordinaries was up 0.6 of a percent today,’ what he means is that the top 500 companies on the exchange went up by an average of 0.6%. Some companies will have gone up by more than this, some by less. Some might even have gone down.

index funds

An index fund is therefore sometimes described as an investment in the stock market as a whole.

Indexing involves the fund purchasing a representative sample of shares, in accordance with the proportion of the index that company represents. For example, if a company’s shares make up 2% of the total value of the index, then the index fund will allocate 2% of its investment funds to shares in that company.

Now that you understand what an index fund is, here are a few key considerations to make before making the choice to invest.

The Benefits Of Index Funds

Automatic Diversity

The predominant retail index fund in Australia is the Vanguard Index Australian Shares Fund (‘VIASF’). The VIASF tracks the ASX 300. To do so, it buys shares in approximately 265 companies traded on the exchange. (It does not hold shares in the smallest 35 shares in the ASX 300, as these shares make up such a small component of the index that holding them would not affect the return).

It would be virtually impossible for any individual to own shares in these 265 companies in their own right. The administrative and brokerage burden would be too great. Therefore, the index fund offers the most efficient (in terms of time and money) means of owning a diversified fund.

Diversification allows the investor to manage what is known as specific risk. Specific risk is the prospect that a particular share will perform poorly. The index has more than 200 shares, which means the effect on the entire portfolio of one share performing poorly is minimal.

Ease of Management

In addition to automatic diversity, index funds also facilitate easy management. One of the main arenas in which we see this advantage is where a SMSF is used. At the end of the financial year, the index fund manager will provide the investor with a short summary of all the transactions during the year. The summary will also show how the information should be accounted for. A SMSF has to be audited and accounted for each year.

The information provided by the index fund manager typically makes the accounting and auditing task a lot less time-consuming. This provides a ‘double whammy’ effect: not only is the index fund the most efficient way of accessing the markets; the associated costs are minimised as well.

efficiency of index funds

Index Funds and Dollar Cost Averaging

Index funds lend themselves to a simple strategy known as “dollar cost averaging”.

Dollar cost averaging involves regularly buying the same dollar amount worth of assets. For example, on the first day of the month a doctor might invest $1,000 into the index fund – regardless of the price on that day. Because this doctor is investing the same amount of money each time, the number of units will vary according to the price on the day of purchase.

Doctors using dollar cost averaging will buy a greater number of units when the price is lower, and a lesser number of units when the price is higher. This usually skews the average cost within the portfolio downwards. Hence, dollar cost averaging usually allows the Doctor to reduce the average cost of units over time.

Some commentators do not like dollar cost averaging. But we do, particularly with lower risk assets such as index funds. This is because:

  • Investing a smaller amount regularly over time is easier than investing a large amount at one time; and
  • It’s hard to beat the market by timing entry and exit perfectly; and
  • Index funds, with their high diversification and low risk, are suited to long term investing strategies particularly if some debt is being applied.

The Disadvantages of Index Funds

Index funds do have some drawbacks.

Ethical Investing

Some Doctors prefer to not invest in companies involved in certain activities. Gambling, alcohol, mining, timber etc are commonly avoided by what are known as ‘ethical investors.’

Index funds, almost by definition, cannot avoid these types of company. So, an investment in an index fund that seeks to track a substantial index such as the ASX 300 will include shares in companies that the investor might like to avoid.

Some investors get around this by quantifying the amount of their return that is attributable to the undesirable companies and offering this amount to charity. For example, the investor might calculate that they made $500 from their investments in gambling companies, and donate this amount to a gambling helpline or similar. But of course, doing this reduces some of the advantages of the indexing approach.

Cannot Possibly Beat the Index

The index fund cannot possibly outperform the index. We have actually heard a financial planner describe them as un-Australian for this reason, asking what Australian would make of a cricket team that happily accepts average performance (this was back in the day of Gilchrist and co!).

For this reason, investors who want to beat the market typically steer clear of index funds.

index funds cannot possibly beat the index

So, now you know about index funds, need a little more advice?

Curve Accountants & Advisers offer tailored advice, which will equip doctors with the tools to make an informed decision about future co-ownership of practices. To arrange a no obligation consultation, contact us today.