Index funds are a great way of achieving diversification in your investment portfolio at a low cost and generally with lower risk than actively managed funds. An index is a smaller group of equities, or stocks, which give a representative measure of an entire larger group, for example, the ASX200 is a group of 200 Australian stocks which can be used to represent the performance of the Australian share market as a whole. Index funds track the performance of an underlying index, most commonly by buying the same stocks which make up the index, in the same weightings. The weighting of a stock in an index is basically the percentage of market capitalisation the stock makes up of the total accumulative capitalisations’ of all the equities in the index. Sounds a bit complex so let me give you an example using Glamazon.
Firstly, market capitalization, or how much the company is worth, is the price of an individual share or equity multiplied by the number of shares on issue, so if Glamazon has 1 million shares on issue, which are valued at $10 per share, it would have a market capitalization, or value, of $10 million. Now, if Glamazon was part of an index that tracked the top ten valued companies in a particular sector, and the total market capitalisations of all ten companies was $100 million, then Glamazon’s weighting would be 10% of that index. That means if you were to invest $500 into a fund tracking this index, 10%, or $50 out of your $500, would be used by the fund to purchase Glamazon shares.
You would not own the Glamazon shares directly; however, you would own a share of the fund, which owns the shares. Think of it a bit like a cake. You could buy all the individual ingredients in the right quantities; a cup of this, a tablespoon of that, a teaspoon of this (weightings), and follow the recipe to make the cake (index), or you could go simply buy the cake already made (index fund). You never really owned the ingredients, but they form part of your delicious black forest gateau. If you are anything like me, I can follow the recipe to the letter, and still stuff something up, so like many others, I find I get better results from buying the cake made by a professional.
As the index fund are tracking the underlying index where the market capitalisations do not fluctuate greatly, there is generally infrequent buying and selling of shares, and the fund is quite simple to monitor, which results in lower costs and fees compared to high touch active funds which are regularly trading in pursuit of additional returns. The additional returns, however, are not always attained, in fact, historical data shows that index funds outperform actively managed funds the majority of the time, and almost always over longer time periods.
If you’d like more information on index funds, start a conversation with us today.
You need to consider with your financial planner (or adviser), your objectives, financial situation and your particular needs prior to making an investment decision. Futuro Financial Services Pty Ltd and its authorised representatives (or credit representatives) do not accept liability for any errors or omissions of information supplied on this website
Steve May, Luke Styles and May Wealth Pty Ltd T/A Steve May Financial Services are Authorised Representatives / Corporate Authorised Representative of Futuro Financial Services Pty Ltd ABN 30 085 870 015, Australian Financial Services Licensee, Licence number 238478. Please refer to our website at www.stevemayfs.com.au to reference our Financial Services Guide and business/adviser profiles.
May Wealth Pty Ltd ABN 71 612 234 518 trading as Steve May Financial Services is a Corporate Authorised representative of Futuro Financial Services Pty Ltd ABN 30 085 870 015, Australian Financial Services Licensee, Licence number 238478.
Steve May and Luke Styles are Authorised Representative’s of Futuro Financial Services Pty Ltd ABN 30 085 870 015, Australian Financial Services Licensee, Licence number 238478