Tuesday, April 16, 2013

Investing in Index Funds: A cheap and easy way to invest in the share market

In previous posts I have written about how investing in index funds is one way that I access the share market and it makes the decision about where to invest easier.  In this post I will cover exactly why index funds are so good and why every investor, especially those who are time poor and do not have time to track individual stocks, should seriously consider index funds.

What are index funds?

Index funds are set up by fund managers to track and replicate the performance of a specific index.  Basically it takes a group of stocks or commodities and invests in every one of the assets within that group so that you as the investor get a return equal to that of the index.

  • Index funds can cover the whole share market (often called broad based index funds) or a specific sector (e.g. materials, resources, retail)
    • Broad based index funds will give you the return of the entire market while sector funds will give you a return for that sector
  • Each unit in an index fund gives you access to the shares in that index on a proportionate basis
    • For example if a certain stock makes up 10% of an index, for each $1 you invest in the index, 10% will be invested in that stock (or will give you the same return as that particular stock)
    • The weight of each stock in an index is determined by the index provider (e.g. S&P, MSCI and others)
  • Index funds are managed by a fund manager and are all slightly different
    • Index funds are managed by a provider who you have probably heard of (iShares and Vanguard are two very common ones)
    • All index funds are slightly different in their attempts to match the index returns - it is too complex and expensive to be invested in every single stock (especially for broad based indexes) and constantly be re-weighting to get the exact return of the market 
      • What this means though is that every index fund has tracking error - this is the difference between the actual return of the index and what the fund gets
      • It's not really a big deal but lower tracking error is better
What are the type of index funds?

Index funds basically come in two types - listed and
unlisted.  
  • Listed index funds are funds that you buy and sell on the share market through your broker.  They are also called ETFs (or exchange traded fund).  These funds have the lowest MERs (management expense ratios) although you have to pay your brokerage cost every time you buy and sell them.
  • Unlisted index funds are regular mutual funds you buy units in.  They usually have no (or very low) entry and exit costs though their MERs are normally much higher.  They also have the advantage that you can set up a regular investment plan which invests money in it every month

What fund should I invest in?

I am going to do a series of posts on this however it basically comes down to a few questions
  • What am I looking to invest in (share market generally or a specific sector)?
  • Am I paying the lowest possible fee for access to this return?
  • What other fund specific things should I care about?
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