Article utilities

Index funds can deliver strong returns over time but you need to know exactly what youre investing in.

The case for

Mirror

The idea is that you will mirror the performance of the sharemarket, year in, year out. Without having to regularly alter your investment strategy, you should be able to almost match the returns of the market. You dont have to decide between big banks CBA and NAB, as you can have them both in proportion to their weighting on the market. That can mean solid and stress-free investing.

Longevity

Index funds have been around for a long time. Indeed, there are managers that specialise in that form of investing, such as Vanguard, which has been operating in the United States since 1975 and has a major Australian operation as well. So you are engaged in a tried-and-tested process.

Choice

The buying the market approach is found in many asset classes. Apart from traditional products, you can hold enhanced index funds and products from the exchange-traded sector, which aim to give you an index-matching return. Many newer options focus on superior execution in their trading, to try to deliver better results for their stakeholders.

Cheaper

Fees should be lower when you buy the market, compared with more aggressive funds. Funds that are more growth oriented often charge higher fees, because they claim they have to put more work into compiling their portfolio. Whether that is true or not, these products do not outperform the index funds every year, so at times you are paying higher fees for poor returns.

Diversity

Diversity can be achieved through buying the market, because there are so many types of indices on offer: large-cap shares, small caps, overseas assets and a host of others. So you do not have to limit yourself to more traditional investments, you can diversify your portfolio.

The case against

Slump

If the index you are tracking falls, your investment will most likely drop by about that amount as well. Index funds dont stop you losing money, they just try to make sure you dont decline by much more than the index does.

Sloth

Buying the market can make you lazy. You may become numb to genuine investment opportunities because you have decided to take the steadier path offered by choosing index funds, when there could be a sublime chance waiting just around the corner.

Errors

Not all index managers are the same. Just as the active ones vary in their performance, so too can those matching indices, to an extent. It is up to the manager to determine what assets to put into the fund in attempting to replicate the market they are mirroring. The margin they deviate from that objective is called the tracking error. A bigger one is not a bad thing but you do need to be aware of it.

On no, not again!

No excuse

Buying an index does not mean you can avoid doing your homework. You may think you are getting a straightforward global bond fund, only to discover a year later that the currency position within it was not hedged. There are numerous indices available in the investment world and you need to know exactly which one your fund is tracking and how it plans to do that.

Si verdict: Index funds can provide a good core for your portfolio. The better ones offer competitive returns at low costs.

Follow us on Facebook and Twitter

You can follow Smart Investor on Twitter: https://twitter.com/#!/smartinvestr (or @smartinvestr) and on Facebook at facebook.com/afrsmartinvestor