How To Invest In Shares Using Indexed Funds

One of the most frequent questions we get from clients is how they should invest in shares. In this blog we will discuss the difference ways you can go about it and why we recommend indexed funds and how you can benefit.

When it comes to purchasing shares, there are several approaches to consider. One option is to engage a stockbroker who recommends specific shares for you to purchase, and subsequently handles the transactions on your behalf, ideally resulting in a profit. This method relies on the expertise of the broker. However, it's important to acknowledge that predicting market movements is inherently uncertain.  This approach is the most costly because you pay fees to the stock broker evertime you buy and sell.

Alternatively, you can independently manage your investments by opening a trading account. These are available with the major banks and  allow you to buy and sell shares based on your own decisions. This approach requires you to select stocks and make choices regarding when to hold or sell them. One drawback,  is it's time-consuming nature and the fees incurred every time you trade.

The biggest concern we have with these approaches is that, without significant experience in analysing company performance, investors are essentially guessing.  This situation can be likened to playing 'pin the tail on the donkey.'  Also, many investors may hold only a small number of shares and  do not diversify their portfolios, which in turn increases their risk. 

We believe a more prudent strategy, involving the use of index funds, which is simply a managed fund. The concept is simple:   You invest in an index fund, such as the ASX 200, where a fund manager endeavours to mirror the composition of the index through its holdings.

Here's how they work and why they're advantageous

• Simple Structure: Indexed funds are passively managed, meaning they don't rely on a team of active managers making decisions about which stocks to buy and sell. Instead, they aim to replicate the performance of a particular index by holding the same stocks in the same proportions as the index itself.

• Diversification: By investing in an index fund, you're effectively buying a small piece of every company in the index. This diversification helps spread risk because if one company in the index performs poorly, it's balanced out by the performance of other companies in the index.
• Low Costs: Because index funds are passively managed, they typically have lower fees compared to actively managed funds. This is because they don't  incur the expenses associated with hiring fund managers to research and select individual stocks.
• Consistent Performance: While index funds may not outperform the market, they aim to deliver returns that closely match the performance of the index they track over the long term. This can provide investors with more predictable returns compared to actively managed funds, which may underperform the market due to higher fees or poor stock selection.
• Transparency: Index funds are transparent in their holdings, as they aim to replicate the composition of a specific index. Investors can easily see which stocks are held within the fund, as they typically mirror the stocks in the underlying index.

Overall, indexed funds offer a straightforward and cost-effective way to gain exposure to the broader market or specific sectors, providing diversification, low costs, and consistent performance over time. They're particularly suitable for long-term investors who are looking to build wealth steadily without taking on excessive risk.

Case Study: Sarah is a 32-year-old investor

Let's talk about Sarah who works as a software engineer. She's always been interested in investing but doesn't have the time or expertise to research individual stocks. Instead, she decides to invest her money in index funds.

Sarah starts by researching different index funds and decides to invest in one that tracks the ASX 200,  which is a widely followed index of 200 large-cap Australian companies. She likes the idea of owning a piece of the entire Australian stock market without having to pick individual stocks. Sarah also like the fact that Australian shares carry imputation tax credits, which means that she gets a tax credit of 30% on her dividends.  This means she only pays tax on the difference between her marginal tax rate and the 30% tax credit.  This helps Sarah minimise her tax which means the net return on investment is higher.

Every month, Sarah contributes a portion of her pay check to her investment account and uses it to buy more shares of the ASX 200 index fund. She also sets up automatic contributions so she can invest consistently over time using a strategy called dollar cost averaging. 

Over the years, Sarah's investment in the ASX200 index fund grows steadily along with the overall performance of the stock market. She doesn't have to worry about trying to beat the market or constantly monitor her investments because she knows that the index fund will closely track the performance of the ASX 200.

As Sarah gets older and her investment horizon lengthens, she continues to invest in index funds, gradually shifting her allocation to more conservative investments to protect her savings as she approaches retirement.

By the time Sarah is ready to retire, her investments in index funds have grown substantially, providing her with a comfortable nest egg to support her in retirement. She's grateful for the simplicity and effectiveness of index fund investing, which allowed her to achieve her financial goals without the stress and complexity of picking individual stocks.

So, whether you're a busy person  like Sarah or just someone who wants a straightforward way to invest, indexed funds could be a great option for you. They offer convenience, diversification, and a hands-off approach to building wealth over time.

As for the largest indexed funds in Australia, there are a few big players

1. Vanguard Australian Shares Index (ASX: VAS)
2. iShares Core S&P/ASX 200 ETF (ASX: IOZ
3. BetaShares Australia 200 ETF (ASX: A200)
4. SPDR S&P/ASX 200 Fund (ASX: STW)
5. VanEck Vectors Australian Equal Weight ETF (ASX: MVW)

These funds give you exposure to a broad range of Australian companies without the need to pick individual stocks.  Remember, that like any other investment, shares involve risk,  so before investing, it’s important to understand your gaols and tolerance to risk. You must do your research to ensure your decision is appropriate for your persoanl situation and seek professional advice.

What are the returns on shares compared to other asset classes? 

This short video gives you an idea of how shares compare with other investments and the historic returns over the long term. While there is no guarantee of future performance, it gives us a basic understanding of how different assets classes perform over the long term. 

I hope you enjoyed reading this article. If you would like my team and I to help you, please contact us for a free no obligation meeting.  - Chris Tolevsky 

Disclaimer: This information is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice.