What is an index fund?

What is an index fund?

Joseph Darby

Is this passive approach to investing right for you?

Thousands of indexes track the movements of various sectors, markets, and investment strategies every minute, hour, and day. They are used to determine that market’s health and performance. The most followed index worldwide is the Standard & Poor’s 500, usually referred to as the (S&P 500). The index can also act as a market's benchmark, or way of measuring performance.

You cannot directly invest in an index, as it is purely a mathematical measure. However, you can invest in an index fund. An index fund is a type of managed fund (sometimes called a mutual fund) or exchange-traded fund (ETF) constructed to match or track the components of any particular financial market – meaning the index fund should “contain” investments in that index.

Index funds aim to simplify investing, which can be tedious, time-consuming, and utterly confusing. If you know what you are doing and have the time, constructing and maintaining a well-diversified portfolio shouldn’t be an issue. But most of us do not have enough time to analyse our investments in sufficient detail – and let’s not forget, this includes time to buy, sell, monitor, and rebalance almost constantly.

Index funds are one solution to this issue. Index funds can give you instant diversification and a passive way of investing in a broad array of industries – with as little as a single fund.

Background – active or passive?

An active management approach to investing aims to beat the return of a given market by making intelligent investment choices. An active strategy operates on the idea that smart humans will be able to outsmart the markets — and over the last year or so some have done so superbly.

"Indexing" is a form of passive fund management. Instead of a fund portfolio manager actively picking investments and trying to time the market – that is, choosing securities to invest in and the best time to buy and sell them – the passive fund manager builds a portfolio whose holdings mirror the particular index. The idea is that by mimicking the profile of the index – the overall share (stock) market, or a broad segment of it – the fund will match its performance as well.

Asking whether active or passive equity management is superior may be the wrong question. Results for the two approaches are cyclical – much research indicates that each has historically delivered extended periods of beating the other.

In general, index funds can be a sound investment. Over the past 10 years, index funds have consistently outperformed most actively managed funds. That said, over most of the last decade investment markets were highly favourable. Especially since the emergence of Covid-19, markets have been more turbulent, with a larger gap between winning and losing investments. In theory at least, this should favour an active management approach which can avoid businesses and parts of the economy that may never be the same again, and instead invest more heavily in the areas and businesses and industries that are most likely to benefit from major global trends that Covid-19 has sped up.

Pros of index funds

  • Simple nature.
  • Usually, lower cost. These funds have no need to hire portfolio managers, stock researchers, and pay trading fees from constant trading.
  • Most are highly diversified.
  • Transparency. Many index funds simply hold what's in the index (which rarely changes) so investors can see the fund's holdings anytime.
  • If you’re someone who merely wants to invest in index funds and nothing more, the amount of research you’ll need to do and the tools you’ll need will be less than someone who actively trades individual stocks.

Cons of index funds

  • They’ll never beat the market. Any investors return will always be just lower than the market, after the funds management and trading fees are subtracted, and after taxes.
  • Lack of flexibility. When the market plunges, index funds plunge with it. It may also be difficult to avoid irresponsible or unethical investments.
  • There are so many index funds to choose from that knowledge and skill is required to select the best one (or several) to suit each investor.
  • In the same way that many NZ products are more expensive than overseas equivalents due to our small size and lack of economies of scale, NZ-based index funds can typically be ten times more expensive than overseas products.

To address some of these shortcomings, you can always keep a mix of index funds and other investments to give you greater flexibility. If you plan on solely using index funds, then you'll have to get comfortable with their limitations.

Thematic index funds

While most index funds track a large index, thematic index funds have recently emerged to buy slices of any “exposure” you may want.

Naturally, concentrating on a sector of the economy or a certain type of asset comes with increased risks. For instance, an index fund tracking the volatile oil and gas sector may be much riskier than a bond index fund.

The fees on these thematic index funds can also be a lot higher than on larger index funds which track more mainstream indexes.

How to invest in an index fund

There are now a range of index funds available to New Zealanders, which is a significant improvement based upon just a few short years ago! Here are some of the ways that everyday Kiwis can invest into index funds which are passively managed:

  • Exchange Traded Funds (ETFs). Usually purchased in the same way shares are purchased through an online brokerage.
  • ‘Unlocked’ passive managed funds – sometimes called a mutual fund.
  • Passively invested KiwiSaver Schemes.

As a general guideline, most ETFs are passive index funds, while many ‘unlocked’ managed funds are actively managed. Most KiwiSaver Schemes are also actively managed.

Which index fund is for you?

Choosing an index fund or funds starts by asking many of the routine questions any investor needs to answer, including:

  • Risk tolerance: What is your personal approach to investment risk versus return?
  • Goals: What are you trying to achieve?
  • Time horizon: How soon will you need the money?

After that, the following questions may assist:

  • Market beating: Would you like to attempt to beat the market, or just keep approximate pace with it?
  • Fees: How important to you is the cost of investing?
  • Strategy: Does this fund's strategy fit your investment goals? What are the specific risks associated with the fund?

The bottom line

Index fund investing can be a welcome addition to any investment portfolio, and the increase in the number of index funds on the NZ market is great news – it gives us all much more choice.

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