Noel Whittaker's Blog Interest rates are dropping, with indications that the trend is still downwards. This has meant that many investors are looking for ways to get their portfolios back on track. Index funds are often talked about, but I often hear comments like “aren’t they risky – what will happen the next time the market falls?”
There is also a lot of confusion about how index funds work. In this context an index fund is one which replicates the All Ordinaries Index which is a number which matches the total value of all the shares on the Australian Stock Exchange. Investing on the index, is like backing every horse in the race.
The one I use myself is an Exchange Traded Fund (ETF) issued by Vanguard. The fund is listed on the ASX – the code is VAS. An alternative to an index fund is an actively managed fund where the stocks in the portfolio are selected by the fund manager. This makes the ongoing fees of an active fund higher than that of a low-cost index fund.
Both investment products are fine in the right circumstances, and there is no doubt that a top active fund should outperform a passive index fund. But the reality is that over 80% of actively managed funds do not beat the index after fees have been taken into account.
Potential share market investors have two choices – talk to an advisor and be guided by what they tell you are the bests fund for your situation. Or, just simply pick an index fund.
Remember, every investment decision has advantages and disadvantages. In a roaring bull market, the index fund may beat an active fund but if a crash comes the index fund may well fall further. This is not a problem for experienced investors who realise that the index having fallen has never failed to recover and reach a new high, but it is diabolical for inexperienced investors who may well panic and cash out at the bottom of the market.
This is why you should never invest in share-based investments unless you have a 7 to 10 year term to give time for the portfolio to recover when the market does. Also, keep in mind that the index is currently paying 4.2% per annum – this will almost certainly continue irrespective of where the market sits.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. noel@noelwhittaker.com.au