What is ‘index’ investing (and what are index investments)?
Index investing involves using a type of investment to track an index. The index can be anything from ‘Australian shares’ to ‘international technology companies’, or even following a commodity index such as gold.
Index funds are a category of investment funds that are designed to track a particular index. For example, the ‘Vanguard Australian Shares Index Fund’ is designed to track the performance of the Australian sharemarket index.
Index funds are usually either managed funds (unit trusts), or ‘Exchange Traded Funds’ (ETFs) that are traded on the sharemarket, similar to a normal share. Both fundamentally are designed to do basically the same job for long-term investors.
There is an index for just about everything; bonds, stocks, property, and even cryptocurrencies. Many assets have several indices covering them, owned and maintained by different index providers.
Why Index Funds?
Picking winners is hard. This has been proven time and time again throughout history. Even fund managers often fail to beat or even match their indices (benchmarks). Index funds don’t try and find the needle in the haystack. They buy the whole haystack.
It’s worth noting that it is very possible to outperform indices over a given time scale and given the large number of active funds statistically some will do so. Over the years some fund managers have become well known for having done so, and a small number have even managed it with some long term consistency.
Almost all, however, fail to beat the market consistently (especially after their hefty fees) or, crucially, predictably in advance. Some “superstar” active fund managers have crashed and burned spectacularly with huge losses for investors despite years of outperforming their indices.
This is a critical point – picking winners works until it does not, and there’s no knowing when that time will come. A regular contributor to the ukpersonalfinance subreddit posted a very detailed review of his own experiences of investing outside of index funds here and it is strongly suggest you read it – it’ll help you understand the concept of Opportunity Risk, the risk that doing one thing with your money will be worse than doing something else with it.
You may see people refer to “buying an index”. An individual investor can’t actually buy an index directly. Instead, you buy a fund that ‘tracks’ that index. The fund will aim to replicate the returns of the index, and one important measure of a fund’s success is its “tracking error” (the lower the better). One of the major sources of tracking error is the management fees charged by the fund, but for index funds these fees are typically low.
For example, imagine buying one share of every publicly-listed company in Australia. (hundreds of companies…). Whatever happens to the Australian sharemarket in a given day will be replicated in your holdings. Although this isn’t practical, the point is that rather than trying to pick which companies will do better than the rest, just buy one of everything.
Over time due to many factors the market as a whole tends to rise more than it falls – inflation, technology advancement, productivity gains, population growth, and more.
There’s very often another benefit to index funds. Due to their simplicity – a single, unchanging aim of tracking their index – they are almost always cheaper than actively-managed funds. Read more about why fees matter here – small differences in fees matter a lot over decades.
Which Index ETFs?
The most popular providers of index investments in Australia are: