Why Use Index Funds?

Vanguard has an array of indexed funds that offer a variety of key benefits over actively managed funds. These benefits include:

• Low Cost
  
• Dependable, broad diversification
  
• Simplicity with no style drifting or bias
  
• Performance advantages
  
• Tax advantages

Courtesy of the Vanguard Australia website, we will discuss these features in more detail below:

Diversification

Index funds allow you to effectively "buy the market". Being so broadly diversified means you're less exposed to the performance fluctuations - either good or bad - of any one share or security.

It is difficult to pick the securities that will perform well. Instead of trying to outsmart the market in the short term, it is generally better to be well diversified across the market.

The overall effect of diversification is that you moderate the volatility of your portfolio and "smooth out" your investment returns over time.

Simplicity

Index funds take the guesswork out of investing. You don't have to try and analyse the strategy of various managers to choose one you think can outperform the market.

Index funds eliminate the worry of trying to "pick winners" or attempting to time markets.

Performance Advantage

Over time, few actively managed funds have outperformed their comparable index. The following chart shows the percentage of fund managers who have underperformed their benchmarks.

Note: Past performance should not be used to predict future returns.

It is very difficult for an active manager to continually pick winners. In nearly all asset sectors, the index has returned more than the median active manager. The reason is simply that the high costs of active investing make it difficult for managers to get ahead of the index. Of course some actively managed funds will outpace their comparable index at certain times. Whether this is due more to "good luck" or good management is very difficult to determine.

An index fund manager simply aims to capture the market return of the assets making up the targeted index. As a result, the fund returns should closely track the market return, less fund fees. With the added advantages of reduced transaction costs (due mainly to less trading than the average active manager) and low management fees, index funds can be expected to provide very competitive performance over the long-term.

Cost Advantage

Index investing has an inherent cost advantage. The indexing strategy minimises fund costs, which can take a hefty chunk out of your investment returns and significantly reduce the growth of your assets over time. Index funds have:

Low Management Fees. An index fund typically has a lower management fee than an actively managed fund because there is no need to employ highly paid research and investment team analysts. A low-cost index fund might have an Ongoing Fee Measure (OGFM) of about 0.80%* (or $8 per $1,000 invested). In comparison, the annual OGFM for an average managed fund is around 1.6%,* or $16 per $1000 invested. Over time this can really impact your returns.

Low Transaction Costs. An index fund tends to buy and hold securities and does not regularly trade in order to out perform the market. In contrast, an actively managed fund will typically regularly trade securities, incurring higher brokerage, stamp duty and other costs, than the average index fund.

* The OGFMs used are based on an investment of up to $50,000.

Source: Vanguard using ASSIRT Research as at January 2004.

The chart below shows the value of two investments with different fees. The lower fee fund (Fund A) returns $2,953 more than the higher cost fund (Fund B) over the 10 year period.

Note: This example does not relate to any particular funds.

Tax Advantage

An indexing strategy has a major advantage over actively managed funds - one that's often overlooked - tax efficiency.

Managed fund returns are calculated before taxes. The actual returns you pocket are reduced by the amount you pay in taxes on your earnings. The relatively low trading activity in index funds gives them a tax advantage over comparable actively managed funds.

Here's why:

When a managed fund sells securities at a higher price than it paid for them, it realises a profit, called a capital gain. The fund subtracts its capital losses from its capital gains to determine its net capital gains, which it distributes to unit holders. Investors are then liable for tax on this distribution, in the year of the distribution.

Generally, the more frequently a fund buys and sells securities-that is, the higher its "turnover rate"-the more taxable capital gains it is likely to distribute, the more of its total returns may be consumed by taxes.

Because the objective of index funds is to match the investment performance of a target index, the funds tend to trade securities infrequently. Rather, they buy and hold all-or a representative sample-of the securities in the index. Trading occurs mainly when the composition of the target index changes or in response to applications and redemptions.

Low portfolio turnover means fewer capital gains distributions and generally a smaller tax bite for investors.

Disclaimer:

No investment advice provided to you.
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You should assess whether the information on this web site is appropriate to your particular investment objectives, financial situation and investment needs. You should do this before making an investment decision on the basis of the information on this web site. You can either make this assessment yourself or seek the assistance of any adviser.