Last updated: July 8th, 2024
Rather than investing in individual stocks, an index fund allows you to invest in a range of stocks or asset classes with one purchase. You can diversify your portfolio and save a lot of time by learning how to invest in index funds in Australia.
Over a longer timeline, the broader market — as measured by index funds — has historically delivered better returns than professional fund managers.
Let’s explore the ins and outs, pros and cons of buying index funds, and popular ways of incorporating them into an investment strategy.
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What Is An Index Fund?
Index funds are investment vehicles that aim to replicate the returns of a specific index on a stock exchange.
Index funds are called passive investments – because the fund manager builds a portfolio in line with an index rather than actively picking individual stocks.
(Related: Cheapest Stock Brokerages In Australia).
Index funds usually fall into two types of products:
Exchange-traded funds (ETFs):
- Australia’s most popular ETFs track broad market indexes.
- Listed on the ASX and bought and sold like shares with real-time pricing.
- Typically have low management fees, but attract brokerage costs on each trade.
Managed funds / mutual funds:
- Traded off-market through fund issuers, at prices they set daily.
- Generally, don’t attract a fee for buying or selling units in the mutual fund.
- Typically require a higher minimum investment and attract higher management fees.
How Do Index Funds Work?
You can’t directly invest in a market index. By buying units of an index fund, you’re pooling your money with other investors, gaining access to the returns on a basket of assets that reflect the makeup of an index.
- The financial assets are held by the investment company that issues the fund.
Indices are developed by specialised firms — like S&P Dow Jones — to provide a standardised measure of a market’s performance.
This helps investors compare performance over time and evaluate investments using an index as the benchmark.
(Related: How To Start Investing In Gold).
In offering an index fund, an investment company:
- Chooses a specific index to track and sells units in the fund to investors.
- Uses investor funds to buy assets in the same composition as the index.
- Administers and adjusts its assets as the companies/assets included in the index change.
You’ll receive returns (capital gains and dividends) from the fund provider proportional to the number of units you own in the index fund.
Above: S&P500 notches forth-straight record high in 2024, after a rocky 2022.
What’s The Cost Of An Index Fund?
Index fund issuers charge an annual management fee, but because there’s less research and expertise required to manage the portfolio, this fee is comparatively low.
Leading broad-based ETFs in Australia have an MER of 0.1 – 0.3%.
(Related: Which ASX ETFs Have Exposure To Nvidia Stock)?
What’s An Example Of An Index Fund?
Some examples of index funds available to Australian investors include:
- Popular Australian large-cap company ETFs like Vanguard Australian Shares Index ETF (ASX: VAS), iShares Core S&P/ASX 200 ETF (IOZ), and Betashares Australia 200 ETF (ASX: A200).
- Global shares index funds like Betashares NASDAQ 100 ETF (ASX: NDQ) and SPDR S&P Global Dividend Fund (ASX: WDIV).
- Sector-based index funds like Betashares S&P/ASX Australian Technology ETF (ASX: ATEC) and iShares Global Healthcare ETF (ASX: IXJ).
Important!
Not all index funds track relatively ‘safe’ broad markets. Indices are available across assets, including company shares, bonds, forex currencies and commodities, and also different sectors, market segments and investment styles. You have many index funds to choose from, with varying levels of risk.
What Are The Benefits Of Investing In Index Funds?
Index funds help retail investors address two core criteria for wise, low-risk investing because they help you:
- Diversify your investments by giving you access to a collection of assets or financial markets in one trade.
- Take a long-term outlook, by simply following the market returns over time.
Index funds are also easy to invest in for beginners. For instance, when you choose an ETF that tracks an index, you can:
- Select and self-manage your investment using an online trading platform (see below for recommendations).
- Quickly and conveniently buy and sell units (representing multiple stocks) in one transaction, anytime.
- Reduce your investing costs and effort required to keep tabs on your investment’s performance.
(Related: What Is Short Selling?)
What Are The Downsides Of Investing In Index Funds?
In addition to the inherent risks that come with any investment (e.g., the market can fall in value, and you can lose money), a key downside of index funds is that they don’t aspire to outperform the stock market.
(Related: How To Invest In Stocks – Australian Beginner Guide).
Other potential drawbacks of index funds to consider include:
- Lack of control: While you can do your research to understand the assets likely to be included in an index, which can encompass specific themes or strategies (e.g., ESG goals), you can’t pick and choose the exact companies that will be added to an index fund portfolio.
- Liquidity: The open-ended nature of both ETF and managed index funds means that if investors panic and start selling, you could have trouble recouping your funds quickly. Underlying assets held by the fund issuer may not be adequately liquid.
What To Do Before You Buy Index Funds.
Before you add international and/or ASX index funds to your portfolio, ensure you’ve familiarised yourself with the risks and the playbooks.
1. Learn How Indexes Are Designed.
Various indices exist, and they differ in the assets they measure, as well as the underlying methodology used to measure them.
Common types of indices that investment funds in Australia track include:
- A broad-based index that covers company stocks across an entire market. For instance, the ASX 200 measures the top 200 companies listed on Australia’s stock exchange, and the S&P 500 represents the US’ top 500 publicly traded companies. Both of these leading indexes use market-cap weighting and free-float adjustment methods.
- A sector-based index that calculates the performance of companies within an industry vertical such as healthcare, resources, finance or technology. A company’s classification in a particular sector is based on how they make the majority of their revenue and how they’re perceived in the market. Classifications are reviewed annually.
- A market-cap or emerging markets–based index. For example, indices that include a selection of small or mid-sized companies; or stocks of companies focused on untested fields like AI, biotech or climate tech.
Important!
Australian investors have flocked to ETFs that track high-profile indexes encompassing the world’s largest companies because it’s easy to research and know what you’re getting.
On the other hand, it’s more difficult and time-consuming for a retail investor to uncover information and insights about more niche markets or growing companies with small market capitalisations and short track records.
(Related: How To Invest Money In Australia).
2. Research Funds That Track Your Chosen Index.
Do your research on available index fund products and compare them based on:
- Management fees: Lower fees are better, but low-cost funds are not always the best value. Work out what you’re willing to spend to access your preferred assets.
- Company credibility: Consider the long-term history, size and reputation of the index fund issuer, and also the length of the time the fund has existed.
- Tracking error: Look at the fund’s performance over time and how closely it has matched the performance of the index it is tracking.
Important!
Read the Product Disclosure Statement (PDS) of each investment fund you’re considering. Don’t be seduced by glossy marketing brochures – they rarely tell the whole story. Learn to love reading the fine print.
3. Study The Index Fund’s Risks, Fees And Dividends.
Once you’ve learned how an index fund is built and have studied the actual assets within it, consider whether its risk, fees and dividend policy align with your investment strategy:
- Do the fund’s underlying assets match your risk tolerance (e.g., crypto may be too high, while bonds may be too low).
- What is the Net Asset Value (NAV) of the mutual fund? This is calculated by dividing the total value of the fund’s portfolio, minus liabilities, by the number of shares. It is important because it tells you how much each share in the fund is worth.
- How much and how often will you invest? How do the fund’s features help you (e.g., no fees for purchasing additional units in a managed fund versus the ability to set limit orders to buy at specific prices with an ETF?)
- What’s your approach to dividends? Will you take the cash or reinvest in more units? Does the fund offer a dividend reinvestment plan (DRP)?
How To Buy Index Funds In Australia.
When you’ve found an index fund that aligns with your investment objectives, there are two options for buying units:
To Invest In Actively Managed Funds:
- Apply directly to the investment management company, which is often possible via their website.
- Speak to your full-service stockbroker or financial adviser to have them buy units on your behalf.
Important!
Some unlisted managed funds can be accessed on the ASX using the mFund settlement service, facilitated by the CHESS system and linked to your HIN. You’ll pay a price per unit set by the fund manager rather than a market value, but you can buy and sell units via a share trading app.
To Invest In Exchange Traded Funds via Online Brokers:
- Do your research on the best platform for your needs. Consider brokerage fees, available markets, and usability.
- Sign up for an online share trading platform or mobile trading app that sells index funds you’re interested in. Deposit money to your account.
- Find your selected index fund using the app’s search tools and create an order to buy your desired number of units. You can either use a market order to buy immediately or what’s known as a limit order to buy units when they reach a price you’re happy to pay.
- Monitor your investment and buy or sell additional units as needed. You can use share trading apps to set stop loss orders that will automatically sell units in an index fund if it drops below a value you set.
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Final Words On How To Invest In Index Funds Australia.
While index funds run the full gamut of investment approaches and risk profiles, Australian investors gravitate towards funds that track broad market indexes with a dependable potential for long-term growth.
I hope learning how to invest in index funds in Australia will help you diversify your portfolio with more asset classes.
Jody
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