Index funds are a low-cost way to get started in the stock market and a valuable cornerstone upon which many seasoned investors build their portfolios. However, with low cost also comes the risk that no one is monitoring your investments for future events and downturns.

What are index funds?

If you’ve heard about the stock market or investing in shares, you’ve probably heard about index funds too. An index fund is a type of mutually traded fund or exchange-traded fund (EFT), and a portfolio/collection of stocks or bonds designed to mimic the performance of the stock market.

Index funds are a low-cost, low-risk way to invest in the stock market, since they tend to track stocks from the largest, most stable companies in the world. Since index funds mirror the behaviour of the market, they are a passive investment strategy, as opposed to an actively managed mutual fund, and thus incur lower management fees for the investor.

So far so good? Alright, let’s get into the juicy stuff.

Are index funds good investments?

The low cost, low risk and general ease of purchase make index funds an extremely appealing investment, especially for newer investors. Below we call out a few more of the pros and cons of investing in index funds for you to consider before you take the plunge.

Pros of investing in index funds

Low management fees

As mentioned above, index funds merely track stock indexes rather than requiring active management. This means that your profits from investment gains can go into your pocket rather than going towards fees and expenses.

Low maintenance

Because index funds are, essentially, a bundle of top picked stocks, they make an ideal investment choice for investors who have little time or interest in actively managing their portfolio. Combined with the ‘slow and steady’ growth rate detailed above, this makes index funds ideal for buy-and-hold type investors.

Diversifying short-term risk

Investing in an index fund means you are investing in the performance of hundreds of companies, not just one. This makes you less exposed to the volatility often associated buying shares, since your investment is subject to the performance of many entities and the overall market. In other words, just because one of the companies inside the index fund experiences a drop in share price, doesn’t mean your investment will lose value, since there are hundreds of other companies inside who can balance it out.

Cons of investing in index funds

Vulnerable to market swings and crashes

Because index funds mirror the performance of the stock market, if the stock market crashes, so too does your investment. 2020 is a great example of this, where markets around the world experienced the fastest declines in history following the Coronavirus outbreak. While you might argue that all companies suffer in times of stock market crashes, this is not true – some companies like Amazon and Apple proved ‘too big to fail’, while the health care sector was among the few to outperform the market.

Lack of flexibility

As mentioned above, in times of strife, index funds can become a bit of a liability in your portfolio because you have no control and little visibility about the holdings, i.e. where your investments are. For example, imagine if your index fund had a heavy weighting of companies in the travel and leisure sectors – all of a sudden COVID-19 hits, no one can fly or go on holiday, and your index fund is dead in the water because it’s comprised of all the major airlines’ and hotels’ stocks.

This lack of flexibility also means you can’t “prune” your portfolio when a stock is over- or under-performing. Say there’s a stock that you consider to be overvalued and is bringing down the overall rate of return on your investment, tough, you’re stuck with it because it’s included in the fund. This is the prime disadvantage of passive investment.

Not sure if index funds or a passive investment strategy are right for you?

Why not book a confidential, commitment-free strategy session with one of our advisors to talk about your investment goals?

Getting started investing in index funds

Another benefit of index funds is that they’re easy to get started with; you can access index funds and ETFs on any basic trading account. Any broker worth their salt, and many banking institutions, can help you set one up (they charge similar fees).

When choosing the type of index fund to invest in, make sure you consider:

• Your risk tolerance
• The fees
• How soon you want to see a return

Despite index funds being a “hands-off” approach to investing in the stock market, we do encourage you to get to know a bit more about the fund and companies inside it. For instance, you might want to look inside and see if you’re about to invest in e.g., an ASX 200 fund including stocks like Virgin or Qantas…

Active fund managers will charge you more, but act as your ally/protector against market volatility by actively monitoring your investment.

Conclusion

Index funds are a low-cost way to get started in the stock market and a valuable cornerstone upon which many seasoned investors build their portfolios. However, with low cost also comes the risk that no one is monitoring your investments for future events and downturns.

Raeburn Advisors have been helping people navigate the stock market and get the most from their portfolios for over a decade, through simplified financial planning and advice. Talk to us today to find out how you can get more from your investment.

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This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.