How to invest in index funds in Australia
Get access to a bundle of stocks through a low-cost index fund by following our beginners guide.
If you’re starting to think about investing, you’ve probably heard about index funds. An index fund is a type of low-cost investment fund made up of stocks and sometimes other assets that tracks a financial market index.
But how do they work and what makes them different to other kinds of funds? This guide cuts through the financial jargon to cover everything you need to know about index funds in Australia, their pros and cons and the steps you need to take to invest in one.
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A typical managed investment fund is a collection of stocks and other assets. Instead of buying shares in one company, you can invest in a bundle of them. To deliver profits for their clients, fund managers buy and sell assets within the fund by trying to predict market movements. This difficult feat is known as "active" management.
An index fund is handled differently. It's simply a pool of company stocks that mimics a financial index, requiring little intervention from its fund managers.
To understand an index fund, it's important to know what an index is. A market index is normally a collection of stocks that are listed on a stock exchange. Australia's most well-known index is the ASX200, which consists of Australia's largest 200 companies by market capitalisation. The Wall Street alternative is the S&P 500 index, which includes the top 500 listed companies in the US.
You'll notice these indices are frequently cited in the media because investors use them to track the overall performance of a market. They rise and fall depending on a range of economic indicators and company news. For example, when an economy is healthy, its stock market indices tend to rise because investors feel more confident buying stocks. If trade tensions increase between countries, stock market indices usually fall as investors become nervous.
Index funds hold a selection of stocks that make up an index. For example, Vanguard's Australian Shares Index Fund tracks the ASX300 index, a collection of Australia's largest 300 companies.
If a company leaves an index, the fund manager simply sells its shares and replaces it with new stocks. For this reason, index funds are considered a comparatively safe, albeit less exciting, alternative to directly buying shares in a company.
Because these kinds of funds require minimal management, it's known as "passive" investing.
It's important to note that while index funds have traditionally been managed funds, within Australia, the term "index fund" often refers to exchange traded funds (ETFs).
What is an ETF?An ETF is a basket of securities that's listed on a stock market, such as the ASX. In Australia, ETFs are typically "passive" investments that track an asset or index, but this isn't always the case. You can read more about ETFs in our informational guide.
Confused about the terminology? That's because terms are changing all the time and actually vary across different borders. Despite the popularity of traditional managed (sometimes called mutual) index funds in the US and other countries, there are few such options available in Australia. Instead, many Australian investors use ETFs to track indices as they work in much the same way but are broadly easier to access and have a lower minimum cost requirement.
Here are some of the ways you can get access to ETFs through online trading platforms:
Most ETFs are similar to traditional index funds in that they are low-cost and track a major underlying index, though there are a few key differences:
- ETFs are listed. The main difference is that ETFs are traded like shares on the stock exchange while index funds are unlisted managed funds.
- They're priced differently. The price that you pay for an ETF is its market value depending on its performance on the stock market. The price that you might buy or sell into an index fund is the net asset value of its underlying securities.
- Buying and selling. ETFs can be bought or sold at any time during a trading day, whereas managed funds are only priced at the end of the day.
- ETFs have lower minimum investment. Index funds typically require a higher minimum investment of more than $5,000. Many ETFs can be purchased for less than $100.
- Index funds don't charge a transaction fee. There's almost always a brokerage fee involved when buying or selling an ETF, but index funds tend to skip this cost. This means that a managed index fund can be a good option for investors looking to frequently add small amounts to their fund over time.
- ETFs have lower fees. On the other hand, taxation and management fees tend to be lower for ETFs than traditional index funds.
Simply put, index funds have been proven to outperform many other kinds of investments.
In 2007, one of the world's most successful investors, Warren Buffet, made a $1 million bet that a bundle of active managed funds would be worse off than the S&P 500 over 10 years. He argued that if a fund simply mimicked a major index, it would deliver better returns than a fund actively managed by professionals. A decade later, Buffet won that bet.
The point is that although major indices fluctuate from year to year, they usually rise over a long period of time. For example, the ASX200 index fell by more than 15% during the 2008 global financial crisis. But even if you had invested in the index fund just prior to that, you'd still be in a better financial position today than if you'd not invested at all.
- Index funds cost less. Passive funds require less legwork, so they typically charge lower fees than actively managed funds. In managed funds, high fees can easily eat into any returns gained by the broker.
- They can achieve higher returns. Indices have been proven to frequently beat the average returns achieved by fund managers over many years. Coupled with lower fees they make good investing sense.
- Ease of trade. Many ETFs listed on the ASX are index funds, which are easily accessible on broking platforms.
- It can diversify your portfolio. Investing in an index fund offers access to a range of companies from various sectors.
- They're relatively safe. Index funds are considered a safer alternative to direct stock market investing because indices are generally less volatile than individual stocks.
Of course, no investment is ever 100% "safe" and you should always seek professional advice before making any investment decision. Here are some of the risks that investors need to be aware of:
- You could lose your money. Like any investment, you take the bad with the good. When an index does well, your investment delivers profitable returns, but when an index drops, so does your investment.
- It's not a short-term plan. Passive funds perform best over many years. If you invest in an index fund but find you need the money six months later, there's a good chance you'll have less than you started with.
- Not all assets are safe. Although many index funds track relatively safe major indices, technically any pool of assets can be bundled into a fund. Some index funds track volatile global markets, such as the oil sector, while others bundle in riskier investment assets. Always do your homework.
- Not all ETFs are index funds. ETFs come in all shapes and sizes and not all are passively managed. Some are highly complex and risky. You can read more about different kinds of ETFs here.
|SPDR S&P 500 ETF Trust||S&P 500||ETF|
|iShares Global 100 ETF||S&P Global 100||ETF|
|SPDR S&P/ASX 200 Fund||S&P/ASX 200||ETF|
|Vanguard Australian Shares Index ETF||S&P/ASX 300||ETF|
|Vanguard Index Australian Fund||S&P/ASX 300||Index fund|
|iShares North America Index Fund||MSCI North America||Index Fund|
Most major fund managers offer access to a limited pool of index funds, though ETFs are the more readily accessible option within Australia.
Traditional index funds can be purchased directly through their associated fund providers, such as Vanguard Investments or BlackRock. ETFs can be purchased with any regular stockbroking account.
Whether you want to invest in an ETF or an unlisted index fund, these are the steps you need to follow:
1. Consider your strategy
Ask yourself what you want to achieve through this investment. Consider your time frame and how much risk you're willing to take on. Will you need to withdraw the funds in a year's time or can they sit for 10 years?
2. Assess your options
Compare funds online to find a product that matches your goals. Consider the risks, the fund's performance, the brokerage fees and other transaction costs.
Key things to take into account when deciding on an index fund:
- Brokerage fees
- Transaction fees
- The fund's performance over the last 3, 5 and 10 years
- Are the fund's assets safe or does the fund contain some volatility?
- The minimum investment amount and how often you plan to transact with the fund
3. Sign up through a fund manager or online broker
Once you've found the right product, you'll need to work out the best way to access it.
Index funds can be accessed through their fund providers such as BlackRock or Vanguard Investments.
- When applying directly to a fund manager, you'll need to fill out an application form, provide proof of address, ID and tax file number. This will need to be posted or emailed back with a cheque or proof of transaction.
- Financial planners can also apply for an index fund on your behalf.
Some online brokers such as CMC Markets have access to managed funds through a settlement service, such as the ASX's new mFund, but at the time of writing there are no index funds accessible via the mFund service.
ETFs are accessible on most online trading platforms and can be purchased just like any other stock. You'll need to sign up for an online share trading platform. To do this, you'll need to:
- Provide personal details and proof of ID
- Transfer money into your trading account
- Log in to your account
- Search for the ETF you want and place a buy order
For more information about ETFs make sure to check out our extensive guide.
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