Investing in ASX index funds

What is an index?

To understand what an index fund is, it's essential to first know what we mean when talking about an 'index'. In finance-speak, an index or 'indices' refers to a collection of stocks, bonds, or other financial assets grouped based on specific criteria and weighting.

For example, the S&P/ASX All Ordinaries Index (ASX: XAO) – or 'All Ords' to its friends – is the oldest index in Australia and comprises the 500 largest ASX companies weighted according to their market capitalisation. The index's composition will change as companies grow, merge, or delist from the exchange, but it provides a consistently good proxy for the overall Australian share market returns.

The All Ords is a broad index covering the majority of shares on the market, but shares and other financial assets can also be grouped based on all sorts of criteria, creating a range of different indices. Some indices focus on specific industries or sections of the market, like the technology and healthcare sectors (S&P ASX All Technology Index (ASX: XTX) and S&P/ASX 200 Health Care Index (ASX: XHJ), respectively). 

There are also indices based on specific investment themes or styles, like high growth or value shares or companies that pay high dividends. Some indices comprise shares in international markets, local markets, or combinations. Some indices are even based on emerging macro trends, like companies that may benefit when interest rates rise.

There is an index for just about everything – including indices for other financial assets like bonds, commodities, currencies, and even cryptocurrencies!

What is an index fund?

An index fund aims to mirror the performance of a specific index of stocks, bonds, or other financial assets. The fund manager raises money from investors by selling units in the fund, which it then uses to buy assets matching the make-up and weighting of the index it has chosen to track.

For example, if you invested in a fund that tracked the All Ords index, it would be like owning a small piece of each of the 500 companies that comprise that index. This is what makes index funds such a powerful investment, particularly for individual retail investors. You can quickly diversify your portfolio across a broad basket of stocks, bonds, or other assets in a single trade.

In exchange for administering the fund and ensuring it always closely matches the index's composition, the fund manager will collect an annual management fee. This fee is usually expressed as a percentage of your investment. It will often vary depending on the fund, so checking how much you'll be paying before investing is important.

For example, if a fund charges an annual management fee of 0.1%, you'll pay $10 annually for every $10,000 invested.

There are many different index funds out there, but the ones that typically list on the ASX are called exchange-traded funds (ETFs). These funds trade on the share market more or less like ordinary shares, making them easily accessible for the everyday investor.

Why invest in ASX index funds?

We've already covered the key benefit of index funds: diversification. Index funds enable regular investors to invest their money across a broad range of assets at comparatively low costs.

We know we shouldn't put all our eggs in one basket – if the basket breaks, we lose all our eggs. The same holds for investing in the financial markets. We don't want to put all our money in one company in case it goes bust. But true diversification can be very difficult to achieve for the individual investor.

Imagine trying to invest in every company in the All Ords index – not only would you require the capital (and patience!) to invest in all those individual companies, but you would also incur brokerage and other transaction fees every time you executed a trade. These fees add up quickly and can make diversifying seem prohibitively expensive.

But herein lies the magic of index funds. In just one trade (with one brokerage fee!), you can invest your money into a class of assets that aligns with your investment goals.

Rather than investing $1,000 in Cochlear Limited (ASX: COH), you could invest the same $1,000 in the iShares Global Healthcare ETF AUD (ASX: IXJ), which gives you instant exposure to some of the largest biotechnology, healthcare, and pharmaceutical companies in the world.

Many index funds also pay out regular dividends to their unit holders. These are generally called 'distributions'.

Top index funds on the ASX

There are currently well over 200 exchange-traded funds listed on the ASX, many of which mirror the performance of specific indices. Below are three of the biggest funds ranked by market capitalisation from high to low, along with their benchmark index.

Vanguard Australian Shares Index ETF

This ETF aims to track the performance of the S&P/ASX 300 Index, which comprises the 300 largest companies on the ASX. This includes mining giants like BHP Group Ltd (ASX: BHP), the big four banks, and leading healthcare companies like CSL Limited (ASX: CSL).

It's important to note that all these funds aim to replicate the performance of their benchmark index before fees, expenses, and tax – which is why it is so important to consider fees before choosing which fund to invest in. This fund charges an annual management fee of 0.1% and net transaction costs of 0.02% per annum.

iShares S&P 500 ETF AUD

Managed by global investment management firm BlackRock, the iShares S&P 500 ETF provides instant exposure to the 500 largest companies in the United States. This includes globally-recognised brands like Apple Inc (NASDAQ: AAPL), Visa Inc (NYSE: V), Pfizer Inc (NYSE: PFE), and Walt Disney Co (NYSE: DIS), among hundreds of others.

Investing in ETFs that track overseas indices is hands down the fastest, easiest, and cheapest way for investors to access a diversified basket of international stocks. 

Diversifying into international markets can help reduce the volatility of your portfolio and may even improve your overall returns because foreign markets are often influenced by entirely different economic tailwinds to local markets.

It charges a management fee of 0.04% per annum.

SPDR S&P/ASX 200

Managed by State Street Global Advisors, the SPDR S&P/ASX 200 was the first ETF ever listed in Australia and aims to match the performance (before fees, etc) of the 200 biggest companies listed on the ASX. Its three largest holdings are BHP, Commonwealth Bank of Australia (ASX: CBA), and CSL.

Management costs are 0.13% per annum.

Benefits of investing in index funds

Diversification: As we've already discussed, the main advantage of investing in an index fund is instantly diversifying your portfolio in a single trade. This can lower the volatility of your portfolio and help you grow your wealth sustainably over time.

Ease and convenience: Investing in an index fund is much easier than stock-picking. Investing in an index fund cuts out all the time you would have had to spend researching individual stocks. It takes a lot of the risky guesswork out of investing. In one trade, you can own a small stake in many of the planet's biggest and most dependable brands.

And the cons

Fees: You always need to check what fees you are being charged on your investment. Index funds typically charge pretty low fees as most aren't required to be actively managed by a fund manager. Instead, they just mirror the composition of their chosen index. Still, it's always good to compare the fees of a few different funds to make sure you're getting a good deal. Fees can quickly eat into your overall returns.

Lower returning: Index funds may not provide the same returns as owning individual shares. For example, the share price of BHP might shoot up 10% in a single day in response to a surge in commodity prices. If your portfolio was only comprised of BHP shares, you would get the entire 10% gain. However, BHP may only make up a small percentage of the overall index that an index fund might be tracking, so the fund would only get a fraction of that benefit. The flip side is that if BHP fell 10% in a day, the fund price would not fall by as much.

Are ASX index funds right for you?

ASX index funds are an easy and cost-effective way to quickly gain exposure to a diversified portfolio of shares and other financial assets. 

But with so many different and increasingly niche funds available, it's vital to do your research before investing. Many index funds cater to specific investing styles (like growth or value investing), and make sure you choose the one that's right for you.

Before investing, you should understand your investment objectives and ensure the fund aligns with the historical returns of the index it seeks to track. Always consider the fund's management fees, as these can quickly eat into your potential returns.