Investing in index funds in Australia is a simple and easy way to get your dollar employees working for you. So what is an index fund and why are they so popular with investors?
Thanks to Australia’s market being geared toward high dividend-yielding shares (rather than capital growth), and the franking credit refund scheme, investing in index funds is a very easy and tax-effective way to generate a passive income that can be used to retire early on a moderate income. Read on as I explain further.
What is an index fund?
“Index funds are a way of gaining exposure to an investment market. Most investment markets have indexes that measure their value over time. Indexes cover almost every industry sector and asset class, including Australian and international shares, property, bonds and cash.“Vanguard Australia1
Put simply, an index fund is a financial product that seeks to track a particular stock market index. Most commonly the term index fund is used to refer to Exchange Traded Funds which are a parcel of shares on the stock market.
Usually this parcel is very large, for example Vanguard’s total Australian share ETF, VAS seeks to track the performance of the total Australian total stock market by owning the Standards and Poor’s ASX 300 index. This means it effectively is a parcel of the biggest 300 companies listed on the Australian Stock index.
Whilst individual shares might fluctuate in price, called volatility, index funds track the overall performance of everything lumped in together. The index can go up or down based on investor’s fear and greed in the open market system and so it can experience large price swings. Over a large enough time period, it is shown that the index always rises – see below graphic.
Don’t be fooled into thinking the share price of the index fund is actually that important, because for buy and hold investors that never sell, it is largely irrelevant. The index fund ETF of course passes on the dividends of the underlying stocks to the ETF owner. The dividends (in Australia) typically account for a large portion of the returns – VAS for example pays a grossed up dividend yield which floats around 4-5%, and the capital growth makes up the rest of the total portfolio growth.
Why Should I invest in Index funds?
Investing in index funds offers an extremely simple, reliable and passive form of investment. It benefits from two main advantages of diversification, and volatility.
Index funds have broad Diversification
Investing in all, or a representation of all of the stocks such as the top 300 stocks by market capital, allows investors to spread their risk across the market. This way, they do not concentrate their risk into any one particular company.
Index funds are not as Volatile as the underlying holdings
Investing in individual shares can leave an investor vulnerable to the large price swings, called volatility in the share price. If you buy a share after it has gone up in value, and then try to sell it and it goes down in value, then it is possible for you to make a loss. This aspect can be frustrating for some, as it is impossible to time the market.
Of course, Index funds are still subject to volatility, however it is usually representative of the entire stock market rather than the gut wrenching volatility we can see with individual shares or actively managed funds.
Index funds are as passive as you want them to be
Investing in an index fund is usually part of a passive investment strategy. It is very straightforward, and as individual company risk is eliminated from one’s portfolio, monitoring your individual investments to ‘know when to sell’ is not a factor. You simply buy the index and hold for the long term!
Index funds are a reliable source of income
Investing in individual companies leaves you vulnerable to the whim of the board of directors, or specific market conditions. For example, if you invest in a company purely for dividend income and they then cut their dividend, you can be left a bit frustrated. The index is shown to produce more reliable returns than individual stocks, a benefit of diversification as explained above.
Index funds usually are ultra Low cost
Investing in Index funds through an Exchange Traded Fund typically has a very low management cost. For example, Vanguards VAS fund has a Management expense ratio (MER)2 of .10% Per annum, or $10 per every $10,000 you have invested every year. This is an incredibly low cost, and means that your precious returns aren’t being gobbled up in fees.
“Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life. Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost that an index fund offers.”investopedia.com/terms/i/indexfund.asp4
What kind of index funds in Australia can I invest in?
As discussed above, there are index funds for a broad variety of asset classes, markets, business sectors, industries or market opportunities that you can invest in. Personally I opt for a broad total stock market index fund.
Funds can track the stock market, commodities, property, bonds or even cash (money markets).
Index funds can focus on specific markets; such as Australian, US, European, Asian and even total world funds.
Business sectors or Industries
Funds can focus on consumer goods, technology, mining, medical and health or financial industries.
Some index funds focus on emerging markets, for investors hoping to participate in growing economies. Some also choose more mature and stable markets.
How do I invest in index funds in Australia?
At any rate, to buy Index funds in Australia you will need a brokerage account. I opt for Pearler because it has the lowest fees, and in my book that compliments the whole reason I am choosing an index-based investing style. It also has auto investing, and template portfolios. You can check out my review of Pearler HERE.
Once you have your brokerage account, simply do your research and ask yourself what kind of index fund aligns with your investing style, risk tolerance5 and preference (for example Australian share funds versus American Bond funds).
If you need more help on specifically how to set up your brokerage account and which low cost Index funds to choose, check out the following guides:
- Get Rich By Investing In LIC And ETF Index Funds?
- My Financial Independence Investing Strategy
- Financial Independence for beginners podcast
- Investing in Australian shares for beginners
- FIRE for beginners
Check out the following index style investment ETFs and LICs
- Betashares Australian top 200 index fund (ASX:A200) MER = .07%
- Vanguard Australian shares top 300 (ASX:VAS) MER = .10%
- Vanguard Total US Market (ASX:VTS) MER =.03%
- Blackrock iShares S&P 500 ETF Total US market (ASX:IVV) MER = .04%
- Vanguard Total world ex US (VAS:VEU) MER = .07%
- Australian Foundation Investment Company (ASX:AFI) MER = .16%
- Argo Investments (ASX:ARG) MER = .14%
- Brickworks investments (ASX:BKI) MER = .18%
How do I keep track of my portfolio?
In line with the index philosophy of keeping it simple, I use ShareSight which keeps track of all my holdings, completely free!
Index fund investing is not for everyone, but practically speaking it suits most investors, most of the time. Its simple yet effective strategy is sure to resonate with most of us, and its passive hands-free approach lets us focus on doing the things that really matter – living our lives!
- ‘Introduction to indexing’, Vanguard Investments. Accessed online at https://www.vanguardinvestments.com.au/retail/au/jsp/investor-resources/education/intro-to-indexing.jsp on Feb 5, 2023.
- ‘Management Expense Ratio (MER) & Indirect Cost Ratio (ICR) Explained’, Rask Education. Accessed online at https://education.rask.com.au/2020/01/06/management-expense-ratio-mer-indirect-cost-ratio-icr-explained/ on Feb 5, 2023.
- ‘How a 1% Fee Could Cost Millennials $590,000 in Retirement Savings’, Dayana Yochim and Jonathan Todd, Nerdwallet. Published: April 27, 2016. Accessed online at https://www.nerdwallet.com/blog/investing/millennial-retirement-fees-one-percent-half-million-savings-impact/ on Feb 5, 2023.
- ‘What are index funds and how do they work?’, Jason Fernando, Investopedia. Published (updated): Oct 17, 2022. Accessed online at https://www.investopedia.com/terms/i/indexfund.asp on Feb 5, 2023.
- ‘What is risk tolerance and why is it important?’, Greg McBride, Bankrate. Published: Jan 26, 2023. Accessed online at https://www.bankrate.com/investing/what-is-risk-tolerance/ on Feb 5, 2023.