Investing in Index Funds

An index fund is an investment vehicle designed to replicate the performance of a predetermined benchmark or stock index. It provides a quick and efficient method for investors to instantaneously obtain exposure and diversification to the desired index.

In Australia, one of the most popular indices for benchmarking the performance of the market is the S&P ASX 200 index. The index is constructed by taking the largest 200 shares on the ASX ranked by market capitalization, and grouping them according to their relative weights as a percentage of total capitalization. It is also continuously updated, to account for companies that may have subsequently entered or exited from the top 200 list.

Before index funds were introduced, an investor wishing to gain exposure to the entire list of 200 shares would have to buy each share one at a time, in the proportion of the company’s weight to that of the total index. The amount of effort required to do this, including the transaction costs involved, would make such an undertaking economically impractical.

In an index fund, this grunt work is passed onto professional fund managers. For an investor wishing to obtain exposure to the S&P 200 index, you would simply buy a "unit" in the fund to gain the equivalent exposure of investing in all 200 companies.

The Benefits of Index Funds

The benefits of investing in index funds are numerous. One important reason is the instant diversification benefits they offer as opposed to investing in individual shares, effectively reducing the likelihood that large losses sustained by any single share will severely affect total portfolio returns. Another advantage is the flexibility they offer investors in terms of obtaining exposure to a desired sector, country or region.

The popularity of index funds has resulted in the creation of literally hundreds of indices which investors can choose from around the world, covering almost every region, sector and industry. There are Indices tracking the performance of small capitalisation stocks, to industry specific indices such as those tracking the performance of biotechnology or pharmaceutical sectors, to country or region indices such as the All Ordinaries and MSCI Far East Index, which track the performance of a specific country or region of the world.

In addition, investing in index funds takes away much of the research work and uncertainty for new investors looking to gain exposure to an unfamiliar sector or country. For example, an Australian investor without previous international investment experience, looking to gain exposure into the U.S. pharmaceutical industry, could simply buy a unit in a relevant index fund, knowing they will gain exposure to a basket of the leading pharmaceutical firms in the U.S.

Furthermore, the low cost structure of most index funds mean that expenses and management fees are low, compared with other more 'active' funds, which over time, can lead to substantially improved returns. In summary, the ease and flexibility of investing in index funds along with their low cost structure provide investors with a cheap and efficient way of diversifying their portfolios both domestically and internationally.