For investors looking for a hands-off way to spread their money across a range of shares and potentially other investment classes, an index fund is one option you could consider.
It’s a pretty broad category, however, and there are a number of ways you could approach index fund investing, some of which may be more suitable than others, depending on your situation.
To help you narrow down your options and decide if an index fund is right for you, Canstar asked financial advisor Ben Brett, of Bounce Financial, to explain some of the ins and outs.
What is an index fund?
Index funds invest broadly across the market. Each fund differs, but loosely, its focus is on tracking a particular ‘index’, such as the S&P/ASX 200. Index funds try to benefit from the increase in the share market as a whole, rather than hoping individual companies will increase in value.
How to invest in an index fund – Six steps to success
- Get clear about your goals
- Determine your contribution amounts and strategy
- Determine your withdrawal goals and strategy
- Research index funds
- Consider how best to buy the index fund
- Take action when you’re ready
Step 1: Get clear about your goals
Before investing in an index fund, it is important that you be clear on the purpose of your investment. There is no one right investment, so your goals will dictate how you should invest. Conventional wisdom suggests the average investment cycle is seven years, which gives you an idea of the timeframes you should be looking to hold your investment. As a general rule, I try to avoid any investment in shares if the time period is less than three years.
Understanding how long you have to invest and what you want to spend the money on (i.e., how much money you will need in the end) will help you decide how to go about the next steps.
Step 2: Determine your contribution amounts and strategy
Do you intend to make a one-off investment or do you wish to contribute regularly to your investment? Making a one-off investment can introduce an additional element of risk, as the day you choose to purchase the shares may have an effect on the eventual outcome of their performance. If you do contribute over a period of time, you spread out this risk but potentially miss out on any returns from uninvested money. Depending on how you have chosen to invest (i.e. ETFs or managed funds), you may incur additional fees for either strategy.
Step 3: Determine your withdrawal goals and strategy
How do you intend to withdraw your investment and when? Is it the case that you are investing for a big-ticket item like a car or are you looking to supplement your income prior to retirement? Understanding your withdrawal plan before you start investing will help you to pick the right investment.
Step 4: Research investment funds
Now you have worked out your goals and contribution/withdrawal strategy, it is time to research investment funds. There are a large number of options out there so you’ll need to consider them based on fees, performance and investment philosophy.
If you are working with a financial adviser, they may be able to assist you by narrowing your search to investment funds which may suit your goals.
Step 5: Consider how best to buy the investment fund
There are two common ways you can invest in index funds. In some cases, you may be able to invest directly through the fund, or alternatively you can invest in an ETF via a broker, such as an online share trading account provider.
The option that suits you will depend on how much you have to initially invest (as some have minimums), if you want to contribute regularly and whether you wish to withdraw your investment as a lump sum or in small portions.
If you have a smaller, one-off amount to invest that you intend to withdraw as a lump sum, then you may want to consider an ETF. If, however, you want to contribute regularly and/or withdraw over a period of time, you may wish to consider a managed fund.
Step 6: Take action when you’re ready
If having done your research, sought advice if necessary, and chosen an index fund that matches your goals, it’s important to follow through on your plans.
The world of investing can be overwhelming, and I often see people give up and put it off time and time again.
If you are feeling overwhelmed, you may like to reach out to a financial adviser to help you take action. After all, your greatest asset when it comes to investing is time.
Why invest in an index fund?
It is generally understood that you should diversify your investments. The problem with trying to diversify a share portfolio is that most people don’t have enough money to buy individual shares of enough companies to be adequately diversified.
To get around this, you have the option of buying into an investment fund, such as an index fund. An investment fund pools your money with other investors so that it can buy a diversified portfolio of shares on your behalf. Each fund has an investment philosophy on how it chooses to invest, which helps you know what you are investing in. For example, you may choose an investment fund which focuses on high performing technology companies or perhaps companies who act ethically. An index fund, however, focuses on investing across the whole market and generally doesn’t focus on particular sectors or types of companies.
As index funds are passively managed, i.e. they do not need investment experts to try and pick high performing shares, the fees are generally lower than actively-managed funds.
What index fund options are there for investors?
There are a couple of ways you can invest in an index fund. Each option suits different people based on their circ*mstances and their investment preferences.
Option 1: Managed fund
The first option is to buy into a fund made up of a pool of other investors whose investments are overseen by a manager who aims to follow an index. This is generally referred to as a ‘passively managed fund’. There are usually minimum balances you need to be able to invest directly in a managed fund, so this may suit people who have higher amounts to invest. A fund manager will generally charge a fee to invest your money and this is usually a certain percentage of how much you have invested.
Option 2: Exchange traded fund (ETF)
A lot of investment funds offer the ability for you to buy shares in the fund on the stock exchange. These exchange traded funds usually don’t have minimum investments thresholds that are as high as those of managed funds, so this can be a good option for those who have lower amounts to invest.
Like a managed fund, there is usually a fee to manage this investment which is reflected in the investment performance and is referred to as an ‘Indirect Cost Ratio (ICR)’. Unlike a managed fund, however, each time you buy and sell shares in the ETF, you will usually have to pay a ‘brokerage’ fee. This is the fee you pay to your share-trading platform for the cost of the share purchase or sale.
ETFs may suit people who have smaller, one-off amounts to invest.
Option 3: Investment platform
Another option is to invest through an investment platform. An investment platform, which is sometimes called a ‘wrap account’, allows you to invest in various managed funds with lower minimum balances. The platform will also provide you with consolidated reporting and may have cheaper fees for the investments within it. There is, however, usually an administrative fee for the platform on top of the investment fees.
Who might an index fund be suitable for?
There is no one right way to go about investing. While some people watch the share market daily and like to buy and sell shares regularly, others are looking for more passive ways to invest, freeing them up to focus on other aspects of their life.
An index fund may suit someone who wants a more “hands-off” approach to investing and is happy to contribute regularly, with the hope that the entire market will increase in value over time. There is a lot of dispute about whether an actively managed investment can even beat an index fund, but as we are talking about predicting the future, we will never truly have a definitive answer.
When might an index fund not be suitable?
Even if something is a great investment for others, if it doesn’t suit your goals and needs, it may be a bad investment for you.
You need to consider whether investing in shares is right for you at this point in your life. For anyone who has debt, such as credit card debt or a car loan, you may be better placed to pay off your debt instead of investing, for example.
You also need to consider your timeframe for investment. Most index funds are designed to be long-term investments and may need to be held for a number of years before they will offer any real value. This is because index funds, while generally more stable than individual stocks, can still be volatile investments, meaning they may go up and down in value daily. If you invest in an index fund with a short timeframe in mind, you may need to withdraw your money while the investment value is down, meaning you will lose money.
Finally, it’s always best to think about how much you have to invest, how much you plan to contribute (and how often) and how you plan to withdraw the money (either as a lump sum or in small amounts). All of these factors will determine your investment strategy.
An index fund is simply one of many tools available to you to build your investment strategy, so always start with your ‘why’.
Cover image source: eamesBot (Shutterstock)
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As an experienced financial professional with a deep understanding of investment strategies and market dynamics, I bring valuable insights to guide investors in making informed decisions. Over the years, I have assisted individuals in navigating the complexities of various investment options, including index funds, and have witnessed the transformative impact of well-informed choices on financial portfolios.
Now, let's delve into the key concepts discussed in the article:
1. What is an Index Fund?
An index fund is a type of investment fund that seeks to replicate the performance of a specific market index, such as the S&P/ASX 200. The primary goal is to track the overall market's movements rather than selecting individual stocks. This approach aims to capture the broader market trends, providing investors with a diversified and passive investment strategy.
2. How to Invest in an Index Fund – Six Steps to Success
Step 1: Get clear about your goals Understanding your investment goals is crucial. Consider your investment horizon, risk tolerance, and financial objectives. Index funds are generally suited for long-term investors.
Step 2: Determine your contribution amounts and strategy Decide whether you want to make a one-time investment or contribute regularly. Each approach has its pros and cons, impacting risk and potential returns.
Step 3: Determine your withdrawal goals and strategy Plan your exit strategy in advance. Whether you're saving for a specific goal or supplementing your income, knowing how and when you'll withdraw is essential.
Step 4: Research index funds Thoroughly research available index funds based on fees, performance, and investment philosophy. Seek advice if needed, especially from a financial adviser who can help narrow down options.
Step 5: Consider how best to buy the index fund Choose between investing directly through the fund or using an Exchange Traded Fund (ETF) via a broker. The decision depends on factors like initial investment amount, regular contributions, and withdrawal preferences.
Step 6: Take action when you're ready Once you've done your research and selected a suitable index fund, it's crucial to execute your investment plans. Procrastination can hinder financial growth, emphasizing the importance of timely action.
3. Why Invest in an Index Fund?
Index funds provide a passive investment approach, aiming to replicate market performance without the need for active management. Diversification is a key advantage, allowing investors to gain exposure to a broad range of assets. Additionally, as these funds are passively managed, fees are generally lower compared to actively managed funds.
4. What Index Fund Options Are There for Investors?
The article highlights three options:
Option 1: Managed fund A passively managed fund overseen by a manager aiming to follow an index. Requires a minimum balance and incurs fees.
Option 2: Exchange traded fund (ETF) Offers shares on the stock exchange with lower minimum investment thresholds. Involves brokerage fees for buying and selling.
Option 3: Investment platform Investing through an investment platform allows access to various managed funds with lower minimum balances. However, administrative fees may apply on top of investment fees.
5. Who Might an Index Fund Be Suitable For?
Index funds are suitable for investors seeking a more passive and hands-off approach to investing. Those willing to contribute regularly with a long-term perspective may find index funds aligning with their investment goals.
6. When Might an Index Fund Not Be Suitable?
Considerations include personal financial goals, debt obligations, and investment timeframes. For individuals with short-term investment goals, significant volatility in index funds may pose a risk. It's crucial to align the choice of investment with one's unique circ*mstances and objectives.
In conclusion, an index fund can be a valuable tool for investors, providing diversification and a passive investment strategy. However, individual circ*mstances and goals should dictate the choice of investment approach. Always seek professional advice when needed to make well-informed financial decisions.
