Index Fund

An index fund is a fund that buys the securities in an index and holds them. The index might be the S&P/ASX 200, and the proportions are the ones the index sets. There is no research team with opinions, no trading to beat the market, and no promise to. The fund's job is to be the market, minus a fee measured in fractions of a percent. Indexed ETFs and index funds charge roughly 0.04 to 0.15 percent a year.

The passive-versus-active argument is settled data, not opinion. S&P's SPIVA scorecards have shown for years that roughly nine in ten Australian large-cap active funds underperform the index over fifteen years, after fees. The index fund is the alternative that does not need to win. It owns the market and takes the market's return, less a fee small enough to ignore. The structure differs between ETFs and unlisted funds; the strategy is identical.

The mechanics are replication. The fund buys each security in the index at its index weight, holds them, and adjusts as the index changes - when a company is added or removed, or when a merger changes the weights. Cash flows in and out through subscriptions and redemptions, and the fund trades only what the index change or the flows require. The portfolio is the index, minus the fee.

The fee arithmetic is the second mechanism, and the one that decides the long run. A $100,000 investment at 7 percent gross over 30 years compounds at 6.96 percent with a 0.04 percent MER, finishing at roughly $753,000. The same money in a 1.2 percent active fund compounds at 5.8 percent and finishes at roughly $543,000: a $210,000 gap, which is the cost of the opinions. The management expense ratio entry covers the fee mechanics.

The tracking difference is the third mechanism: the gap between the fund's return and the index's return, fees included. A fund returning 6.92 percent against a 7.00 percent index has a 0.08 percent tracking difference - the fee plus a sliver of trading cost. S&P's SPIVA scorecards measure the same gap from the active side: roughly nine in ten Australian large-cap active funds underperform the S&P/ASX 200 over fifteen years, after fees, which is the scorecard the index fund keeps winning.

For an Australian reader, the index fund is the default answer to the question "what should I buy", and the default exists because the data keeps confirming it. MoneySmart's guidance on investing treats diversification as the foundation and low fees as the multiplier. The index fund is both in one product: the whole market, for a fraction of a percent. The super system agrees - the Your Future Your Super test exists because active management's fees are the outcome funds control. The exchange-traded fund entry covers the ASX-listed wrapper.

A colleague named Brent (yes, that Brent) paid 1.2 percent a year for a decade of active management that underperformed the index in eight of the ten years. Each year he concluded the manager was "about to turn it around". The decade cost him roughly $210,000 against the index alternative on a six-figure balance. The highest-leverage thing most Australians can do is buy the index and keep the fee under 0.15 percent. Spend the energy the active research would have consumed on the savings rate instead.