Here at the Motley Fool, we love spruiking the benefits of owning a diversified portfolio of top ASX shares. However, owning shares can come with its own set of hurdles any investor has to jump. The reality is that some investors might be better off investing in exchange-traded funds (ETFs) that track an index. Index funds can provide a cheap, effective path to investing without some of the hassles that we share investors have to wade through from time to time. And they are arguably a lot better than leaving your cash in the bank. However, index funds won't deliver the kind of share market gains that have made Warren Buffett rich. So which are better for you, ASX shares or index funds? Here's the argument in a nutshell:
3 ways index funds are better than ASX shares
There's not a lot to worry about
The first benefit of owning index funds is that there's just not that much to worry about, at least when comparing them to a portfolio of ASX shares. If an investor has a portfolio of 15 ASX shares, that is 15 companies to keep abreast of. 15 management teams to follow. 15 annual reports to read every year. 15 share prices to potentially watch crater in a market crash. This can easily become overwhelming for any investor, especially one just starting out. You don't get any of that hassle with an index fund. Especially so if you find the whole 'investing thing' boring.
You can leave an index fund on autopilot
One of the best things about an index fund is that it does the work for you. Part of that work is selecting the companies that make up an index in the first place. Fortunately, the providers of an index fund have a simple and effective way of doing this. If a company grows in size, it grows its presence in the index. And vice versa. In this way, the poor companies are weeded out over time, while the best companies are added to. CSL Limited (ASX: CSL) never used to be a large part of the S&P/ASX 200 Index (ASX: XJO). Now it's a top holding.
The index provider does this process for us. So once you buy an index fund, you can leave it in the bottom drawer if you want.
Index funds can outperform managed funds
Managed funds used to be the only way to passively invest in ASX shares before index funds came along. There are many top-notch managed funds out there. But there are also many poor ones too. The problem for investors is that it can take years for patterns of poor performance to become evident in a fund's figures. And while you're waiting, the fund is usually charging you a hefty fee, often between 1-2% per annum. In contrast, index funds have a fee that can be a tenth of that or less. For example, the Vanguard Australian Shares Index ETF (ASX: VAS) charges 0.1% per annum. The iShares S&P 500 ETF (ASX: IVV) costs just 0.04% per annum.
3 ways ASX shares are better than index funds
ASX shares can help you outperform the market
This might go without saying, but it's worth saying anyway. When you buy an index fund, you are signing up for the performance of the broader market. Nothing more, and nothing less. That walks hand in hand with the fact that you can never do better than what the market does if all you own is the market.
Now, an ASX index fund like the SPDR S&P/ASX 200 Fund (ASX: STW) will give you a decent return over time, an average of 8.1% per annum since 2001 in fact. But a top-notch portfolio of ASX shares has the potential to do better than that. Some skilled investors can get to the point where their portfolios generate 15%, 20% or even 30% per annum on average. That takes patience, time and temperament, but it can be done. And if you get to that point with your ASX shares, the benefits of compounding your wealth at that rate become very powerful.
Your ASX share portfolio is free
If you ask someone else, whether that be a managed fund, or an index fund, to manage your money for you, you are going to have to pay them for the privilege. Whilst it's true that some index ETFs offer very low management fees, running your own portfolio yourself will always be cheaper. Fees can add up over long periods of time, so managing your money yourself will always give you the edge here.
You can learn a lot along the way
Investing in an ASX share is the same as investing in a business. You'd be surprised at how your perspective can change when it becomes 'your company's annual report' you are reading. Warren Buffett once said that "I am a better businessman because I am an investor". Investing in individual businesses can help in many other aspects of life, some obvious and some not. Understanding how different companies are planning for the future or adapting to technological change can give a unique perspective that you might not find through other mediums. Good investors like to say that they are always learning. And learning is good for the soul!
Foolish takeaway
We Fools think most people have what it takes to be a successful ASX share investor. But there are some people out there who find the whole process too stressful, boring or hard to follow. And that's ok! Index funds can often fill these gaps so that these investors can still participate in the wealth creation of the markets in a more passive way, without paying through the nose. Index funds can be an easy and useful way to invest in the share market. But there's no doubt that building your own portfolio of ASX shares can be far more rewarding in more ways than one. If you're up for the challenge, that is.
