investing: what is an index fund?

When it comes to investing in shares there’s so much jargon thrown around, and one word you’ll hear a lot in investing conversations is the word ‘index’. “Tracking an index”, “index fund” and “index investing” - what does it all mean and what is this elusive “index” all about? Let’s break down everything you need to know about this term, its context and how it’s used so you can apply it to your own investing plans. If you’re new to investing check out 9 investing basics every beginner should know! Also, consider subscribing to my millennial investor where Nick Bradley breaks down investing concepts and news in a way that actually makes sense! For now, let’s dig into this term ‘index’.

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two typical investment management styles

There are essentially two investment styles when it comes to listed assets (companies or shares on a stock exchange) - active investing and passive (index) investing. We’re going to unbox these ideas below, but let’s start with some basics.

what is an index?

Let’s start with a basic definition: an index tracks the performance of a group of companies, e.g. the S&P/ASX200 tracks the top 200 public companies listed on the ASX (Australian Securities Exchange). Here’s some of the most well known indices you’ll see mentioned in the media and in conversation:

All Ordinaries - the oldest index in Australia. This tracks the share prices of 500 of the biggest companies listed on the ASX.
S&P/ASX200 - as mentioned above, this tracks the performance of the top 200 publicly listed companies on the ASX.
S&P 500 - this tracks the performance of the top 500 public companies in the US.

Example: the ASX200

Let’s use the ASX200 as an example. "ASX" stands for Australian Securities Exchange, which is the primary exchange for Australian shares. The ASX is based in Sydney. The ASX200 is a benchmark index that was created in the year 2000 and consists of the 200 largest public companies by market capitalisation listed on the ASX. As with all indices, the ASX200 is measured in points and tracks the combined movements of all 200 stocks within the index. Daily changes to the index are measured in points or percentages. The ASX200 performs quarterly rebalances, where the index adds and removes firms that have qualified or no longer qualify as ASX200 companies using the previous six months data.

There are basically hundreds of types of indices for various types of asset classes.

Broadly speaking, an index can be a good benchmark and a good sign of the overall market conditions. That’s why it makes news headlines when the ASX200 index falls significantly as a general statement would be that most of the top 200 companies have fallen in value or price that day.

passive investing

It’s exactly that - passive! Not being active or trying to chase the best returns. You essentially buy an index and take whatever the index or market does as a whole. There could be different investment companies who have their own index funds. You could buy into said fund and take an index approach to Australian Shares, International Shares, Property, Fixed Interest. It would be called a balanced index fund if there was a healthy balance between growth assets (shares and property) and defensive assets (cash, fixed interest, bonds etc).

Warren Buffet commonly referred to as the worlds best investor has come out and said that index investing is the way to go!

If you invest in an index fund, the manager will take a fee. I always cheekily say that an index fund will always under perform the index, after fees! You shouldn’t pay too much for index management as they are not doing that much in relation to active managers.

active investing

Yep – you guessed it. It’s the complete opposite. These are investment managers who believe by researching stocks and looking for the best value and buying these stocks to make up a portfolio that they think can out perform the index. There may be specialist active managers who only focus on international shares, up and coming companies, the big stocks like banks or household staples or even funds that will not invest in the top 10 stocks that usually make up an index. They will charge a fee for their expertise which generally means the fee is higher than an index fund. It’s OK to pay their fee if you believe they can out perform the index after their fee or you are looking for a specialty. If you were retired, you may want an active manager to only invest in shares in companies that produce a high dividend (or income) yield. Like anything, advice to your personal situation is always recommended. There are some fancy funds that are “benchmark unaware”. Some managers will also charge an additional performance fee if they return an amount higher than what they originally aimed for.

so what’s it all mean and which one do I choose?

In investment circles, online communities and between general money chit-chat, there is always a great debate between which style wins. It’s a great debate and we love reading people fight with passion behind their keyboard. Interestingly enough, while Warren Buffet tells people that index investing is the only way to go, he himself is an active manager. Like, that’s what he does and how he has made and makes his money. Buying individual companies when the price was low. However, he is a genius and we can’t all be like him. Do yourself a favour and watch the documentary “Becoming Warren Buffett”, it’s an interesting watch.

There are some pros and cons to both approaches - you need to decide what suits your investing goals and the amount of hassle, research and paperwork you want to tackle each year. Consider the following:

pros of active investing:

it gives you the ability to invest in specific companies you love/are interested in
you can manage tax implications more closely
you‘re able to invest in companies that aren’t within a specific index

cons of active investing:

more hands on research is required
more time, paperwork and fees are involved
often times active investing does not outperform passive (index) investing

pros of passive (index) investing:

it’s set and forget
there’s less research and paperwork time required
the fees are lower

cons of passive (index) investing:

you may have limitations on investments, although new products are created all the time
it may be harder to screen companies you don't want exposure to
it's not sexy (but that's good when it comes to investing!)

Glen James’s personal choices around active vs passive (index) investing

There is a time and place for both styles. My personal superannuation investment uses index investing for growth assets and active management for the defensive or fixed interest portion. I choose this because in an era of lower interest rates I believe we need managers to chase the best short term bonds etc. I use some active management in an investment fund I have outside of my superannuation and that fund only invests in Australian companies with an ethical view. This could be no tobacco, no mining, no gambling and only renewable energy. There probably is an index for this though, but the fund I use has an exceptional track record.