Introduction to indexing

What are index funds?

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.

How is indexing different to active management?

Active fund managers try to outperform the index by picking sectors and securities they believe will outperform in the future.

Rather than trying to guess which investments will outperform in the future, index managers replicate a particular market or sector. This means they invest in all or most of the securities in the index.

Indexing is based on the theory that investors as a group cannot beat the market - because they are the market. In fact, when you take costs into account Vanguard founder John C Bogle says investors as a group must underperform the market.

This is why when you look at the performance tables at any point in time there are always winners and losers. Picking consistent outperformers is almost impossible, so indexing provides a way of accessing market performance without the high costs.

What are the benefits of indexing?

Indexing offers two distinct advantages:

  1. Investing in all or a representation of stocks in a market index can maximise diversification and reduce risk.
  2. Buying and holding securities over the long term reduces volatility and investment costs (including tax) and can lead to better returns in the long run.

Types of index funds

Here are some of the more popular types of index funds available today.

  • Full replication - invests in all securities in an index.
  • Partial replication - holds a representative sample of securities in an index.
  • Exchange Traded Funds - managed funds traded on the stock exchange like shares.
  • Enhanced index funds - index funds offering enhanced performance.

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History of index funds

1949: John Bogle, then a young economics student at Princeton University, "stumbled" on a feature article in Fortune magazine about the enormous potential of the funds management. This triggers his interest in investments funds and becomes the subject of his undergraduate thesis.

1951: His thesis is headed: 'Mutual funds can make no claims to superiority over the market averages'. (Mutual funds are similar to Australian unit trusts or managed funds.) Based on painstaking research, he showed how three-quarters of fund managers would not have earned more than an investor who had managed to invest across the index of America's 500 largest companies.

And John Bogle names his thesis as the "seed that germinated" into the first retail index fund established by Vanguard.

1969-1971: Wells Fargo used academic models to develop the principles and techniques for index investing. It was used on a small staff super fund and then abandoned as a "nightmare".

1973: 'A Random Walk Down Wall Street' by Princeton University professor Burton Malkiel is published, calling for the establishment of a low-cost fund that reflected the market index. As it happened, John Bogle did not read this book until some years after its publication.

1974: The American National Bank of Chicago creates a trust based on the US S&P 500 Index, minimum investment $US100,000.

1974-75: John Bogle says that apart from his own findings in his university thesis, the two inspirations for Vanguard's first retail index fund were a 1974 paper by academic Paul Samuelson pleading for a large foundation to establish an in-house index fund, and a 1975 Fortune magazine article by associate editor Al Ehrbar stating that managed funds consistently underperformed because of their costs.

1976: Vanguard under the leadership of John Bogle establishes the first index fund for retail investors, the Vanguard® 500 Index Fund. Today, this is the world's largest managed fund of any type.

1986: Vanguard launches the first bond index fund for retail investors in the US.

US academics Gary Brinson, Randolph Hood and Gilbert Beebower publish their landmark study, 'Determinants of portfolio performance', finding that stock selection and market timing have little impact on an investor's final return, and that long-term asset allocation is the main determinant. The theory behind index funds was, of course, based on much the same reasoning.

1990: Vanguard in the US creates the first international share index funds.

1991: Gary Brinson, Randolph Hood and Gilbert Beebower repeat their 1986 study and reach basically the same conclusions.

1996: The first index funds in Australia are launched by Vanguard for wholesale investors.

1998: Vanguard launches its first index fund for retail Australian investors and its pooled superannuation trusts.

2007: Australia's simplified super is introduced with tax-free retirement benefits for those over 60. This greatly increases the popularity of superannuation including self-managed superannuation funds.

Super funds across the spectrum - from SMSFs to some of the largest funds are increasing using index funds as a means to gain wide diversification for a low cost.

2009: Vanguard launches its range of exchange traded funds to Australian investors.

Core-satellite strategy

The core-satellite strategy is a way of incorporating actively managed funds and other investments into your portfolio while reducing risk and costs.

This strategy appeals to investors who are attracted to the distinct philosophies of active managers, or those who like to invest directly in shares themselves, but prefer a lower risk strategy. It works just as well in diversified investment strategies as it does in single sector ones.

You start with a core of single sector or diversified index funds. You then add individual shares or actively managed funds (the satellites) commensurate with the level of risk and diversification you want to achieve.

Many financial advisers use a diversified index fund to achieve their client's asset allocation and add a combination of lowly correlated active funds as the satellites.

Using low-cost index funds as the core strategy can be an efficient way to implement your asset allocation and reduce your overall costs of investing.

It's important to remember that choosing active managers requires a great degree of skill and diligence. Consistently outperforming the benchmark is very difficult to do.

For those that enjoy the challenge of trying to pick winning active managers, the core-satellite strategy might be worth a consideration.

Indexing can be a powerful strategy when used alone or mixed with active fund managers. In fact, many investment experts believe indexing is the best starting point for any investment strategy.

Vanguard’s indexing approach

Some index managers like Vanguard use optimisation techniques to build portfolios that mirror the index. Rather than holding all the securities in the index like fully replicated funds, the portfolio holds a representative sample. This is called partial replication.

Optimisation aims to reduce the higher costs of owning all the securities in the index while continuing to match the index return. Some indexes contain many illiquid stocks making it impractical and costly to own every stock in the index.

With partial replication, the portfolio still tracks the index closely, but the costs of trading in many illiquid stocks in the small, 'tail end' of the index are reduced. The fund still holds small capitalisation stocks but rather than holding every stock in the index, a representative sample is held.

With optimised index portfolios, fund managers don't need to constantly buy and sell securities when index weightings change, resulting in lower turnover, costs and tax. Trading only becomes necessary when the index constituents actually change, or where buying and selling is necessary to meet applications and withdrawals.

Optimisation takes a large number of factors into account, including the financial characteristics of securities in the index and the correlation in behaviour between stocks. This way, the index manager builds a portfolio that is "optimal", reducing the tracking error of the portfolio relative to the index while at the same time keeping transaction costs low.

Tax-effective investment strategies

Of all the expenses you pay as an investor, taxes have the potential to take the biggest bite out of your total return.

The amount of tax you pay depends on a number of factors including the fund type (for example, super, unit trust, pension), type of assets, your marginal tax rate and the fund manager's investment approach.

How to pay less income tax

By maximising your use of tax-efficient investments, organising your assets in the right types of accounts and employing other tax-saving strategies, you can keep more of your investment returns.

Tax-effective investment strategies include:

  • Buying & holding: If you sell shares or a managed fund you've held for one year or less, you'll have to pay tax on any capital gains at your regular income tax rate. But if you hold these assets for longer than 12 months, you may receive a discount of up to 50% on the capital gain.
  • Using tax-efficient funds: Investing in funds, such as index funds, that have a low turnover (that is, they buy and sell securities relatively infrequently) can reduce your capital gains liability and improve your after-tax returns. Australian shares offer the lowest effective tax rate of all the asset classes due to the dividend imputation system. Some Australian share funds target companies with high franking levels, which can help offset the amount of tax you pay on dividends.
  • Investing in superannuation: You can often make contributions from your pre-tax salary so your money is taxed at the concessional rate of 15% rather than your marginal tax rate.

Do your homework before you invest

A manager's investment approach can significantly impact the amount of tax you pay at the end of the financial year.

Portfolio turnover is one of the reasons actively managed funds tend to incur higher tax liabilities for investors. Portfolio turnover reflects the level and frequency of trading in a portfolio and is an important indicator of tax efficiency. Some active managers can turnover their portfolios by 100 per cent or more in a year. By comparison, Vanguard's buy and hold approach has an average turnover rate of less than five per cent.

Generally, the higher the level of turnover the higher the probability of realising short- term capital gains. Short-term realised gains on assets held for less than a year are less efficient. Long-term capital gains are more efficient because the discounted tax rate effectively halves the amount of tax payable.

When choosing a fund, try and ascertain how the investment processes of your fund manager will impact your after-tax return. Unfortunately, comparing after-tax results is not that easy in Australia, where after-tax reporting is still not compulsory.

Vanguard has been publishing the after-tax performance of its funds since October 2004. Investors can clearly see the after tax results of Vanguard's funds under four different tax scenarios.