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Investing in index funds: 7 myths busted

·4-min read
A man looking at stocks prices on an electronic screen. (Source: Getty)
Index funds can provide an investor with a spread of investments for a small buy-in. (Source: Getty)

If you’re looking for a low-cost way to build up your investment portfolio, you might consider an index fund.

These funds aim to match the returns of a benchmark index – such as the S&P/ASX 200 – by pooling investors’ money to buy a selection of assets in equal proportions to the benchmark’s holdings.

Index funds are well known as low-fee access points to financial markets. They provide an investor with a spread of investments even if they only have a small amount to invest. But there are several common misconceptions about index funds that might surprise you.

Myth 1: ETFs are the only type of index fund

Type “index fund” into Google and many of the search results will be for ETFs, or exchange traded funds. These funds are made up of a basket of shares listed on the Australian Securities Exchange (ASX) and, like shares, are traded themselves. But there are other types of index investment.

Unlisted index funds allow you to hold a variety of shares in a single investment, but rather than buying through the ASX, you deal with the product issuer. These funds have been available for many years but have gone under the radar of some investors.

Myth 2: Index funds won’t beat the Australian share market

Index funds that track the S&P/ASX 200 do not seek to outperform the Australian share market but they do provide the certainty of keeping up with the market. Other index funds track different benchmarks, from global share markets to income-generating securities, and allow an investor the opportunity to spread their investment across a wide range of asset sectors.

Academic studies show that the asset classes you choose – rather than the specific investment – accounts for up to 90 per cent of total returns. By investing in different asset classes, you have the potential to diversify your investments beyond just the Australian share market.

Myth 3: You can’t take much risk with an index fund

In general, index funds mitigate risk through diversification but that doesn’t mean they are risk free or deliver low returns.

And there is a new breed of index fund emerging, one that allows the investor to spread their investment across multiple asset classes.

For example, a high-growth index fund might include investments in global and emerging market shares, infrastructure and property, allowing you to capture the potential returns from high-growth economies worldwide.

Myth 4: Index funds are only available through financial advisers

Financial advisers regularly recommend index funds to their clients because they offer broad, low-cost exposure to investment markets.

This doesn’t mean that only financial advisers can recommend index funds.

You can invest in index funds without an adviser simply by filling in the appropriate application forms on the product issuer’s website.

Myth 5: Unlisted index funds require a large investment

One of the great things about index funds is that they offer wide diversification to investors with only a small amount to invest. You can start small and add to your investment over time.

Having the ability to add regularly to your investment will pay dividends further down the track.

Myth 6: Index funds are costly

Index funds charge lower fees than actively managed funds.

Actively managed funds employ teams of investment analysts to try to beat the markets and this increases the cost of the funds to the investor.

An index fund does not have this cost and the savings are passed on.

As an example, an investor could opt for a fund that charges an annual fee of, say, 0.31 per cent of the balance. So, on a $10,000 investment, that’s a cost of just $31 a year.

Myth 7: You can’t put index funds in your superannuation

Anyone can direct superannuation contributions into their choice of index funds via a retail super fund that offers a wide range of investments.

You will need to fill in some forms and understand the consequences if you decide to switch your super funds. Also, bear in mind that money in superannuation is out of reach until you retire.

Whether you’re investing for now or for the future, unlisted index funds offer easy, flexible and inexpensive access to a wide range of investments.

Scott Tully is general manager of investments at Colonial First State.

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