The Problem with Index Investing


Index investing has been around for a really long time, but it is only recently in Australia that people have been getting excited about it. This is likely a sign of more information and products being available, as well a few major books from life coaches and shoe-less authors talking about the merits of index investment.

At Lime Financial Planning, our adviser Nathan has been recommending clients invest into index funds for his entire career – always with the philosophy “Index unless”. Today’s post explores that indexing in greater detail, as it can be a great way to invest, but it is important to understand the downsides as well.

Index investing is where you put your money into a ‘passive’ or Index ‘managed fund’.

What is a Managed Fund?

When you invest in a managed fund, your money is pooled with other investors. The manager then buys and sells different investments on your behalf.

The manager is a company of investment professionals, and their approach to investing is based on their investment mandate. They charge an investment fee for their services - which is often wroth it, particularly if you don’t have the time, knowledge or amount of money required to manage your own investments.

Chances are you already have managed funds within your super. When you choose your investment option, such as “Growth” that money is held in managed funds.

Managers can be active or passive in their approach.

What is the difference between Active and Passive?

An active manager picks and chooses the investments they put your money into based on their ‘mandate’ – ie how they are allowed to invest for you.

They analyse the investments, and the market and economic environment and actively buy and sell to provide you with returns, trying to ‘beat the market’. When someone refers to ‘the market’ they actually refer to a market index.

A market index is a weighted average of several stocks or other investment vehicles from a section of the stock market, and it is calculated from the price of the selected stocks. You may have heard the all ords’ being referred to on the news? This refers to the 500 largest stocks in the Australian share market, weighted by their size in dollar terms. There are all sorts of indexes, with different rules however most follow this principal.

A passive manager does't pick and choose the investments specifically, they just mirror the index. For example, an ASX300 index fund, would allocate their money into the 300 largest companies in the Australian Stock Exchange (ASX) weighted by their size in dollar terms; mirroring that ASX300 index.

So why invest in Index Funds?

  1. Performance: According to a CANSTAR study around 2 thirds of active managers don’t outperform their index over the long term. This tends to be truer in times where the market is ‘efficient’ and generally in growing markets.

  2. Diversification: Instead of trying to pick which companies are the best, you can just ‘own the market’ and invest across a diversified portfolio of stocks. From our example earlier, you can view the entire ASX300 at this website.

  3. Costs: Indexing is cheaper – with most index funds being between 20% and 50% of the price to invest in of Active managers. This is because they have fewer operating costs, not having to hire as many analysts etc.

  4. Manager Risk: An active fund is (most of the time) run by people, and their investment principals. People can get it wrong.

  5. True to label: You know exactly what you get with index funds. They have a rule that they follow and most index funds map quite closely to that (the difference between the index return and the index fund return is known as tracking error, and not all index funds are the same).

  6. Access: These days most index funds can be invested into via “Exchange traded funds”, with as little of $500. Most active funds need a minimum of $20,000 to get started. There are also a number of services that you can invest into with $1. I won’t cover exchange traded funds in this, however you can read about them at MoneySmart HERE.

So whats the problem with index investment?

Index funds are a great way to get cheap, easy asset exposure – however there are some important downsides you should consider.

  1. Performance: According to a CANSTAR study around 1 third of active managers outperform their index over the long term. It can be done, with the right funds.

  2. Weighting: Indexes are allocated based on the size of the company in the index, not how good of an investment a particular company is. An example of this is the ASX300 from earlier, where the top 10 companies make up around half of the total market. These companies are the big 5 banks, resource companies and supermarkets – whether they are good to invest in or not.

  3. Downside Protection: Index funds build portfolios based on historical data. When markets fall, the index needs to quickly re-balance through the sale of assets in order to properly match to the index. This can result in the crystalising of loss. Alternatively an Active manager can hang on until the market recovers.

  4. The Type: Not all index funds are the same. Invest directly, others use complex financial derivatives to mirror their index. This can add additional risk to the investment.

  5. Asset Class: Not all assets/investments are good to index. This comes down to what is known as efficiency – where the information about the investments is freely available and up to date. The more specific and smaller the asset class, the harder it can be to get information, the more an active manager can take advantage of what they know and outperform. This tends to be the case with small company indexes

  6. Defining the index: Sometimes the index definition or rules result in investment performance that is distorted. For example – infrastructure investment includes assets like roads and trains, but it can also include oil pipelines and power distribution. The latter assets are not priced on their returns but are often a proxy for the commodity (oil price).

New Products

As with anything there are always new products and investments being developed. FOr index investment, an exciting new area is known as 'Smart Beta'. These are a range of managed funds which don't follow the conventional "index" approach. These can make up for some of those downsides, and add a lot of value to the portfolio.

In summary

You should absolutely consider investment into index based funds when you look at investing - but identifying the downsides of these funds, and compensating for them with active investments will build a far more robust portfolio.

Get in touch at nathan@limefinancial.com.au and we can explore your investment options in greater detail.

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