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Around the globe, passive index investing has become hugely popular as it provides a low-cost way to replicate the investment returns of popular indexes like the Dow Jones or the S&P/ASX200.
While some Aussies have dipped their toe into indexing by investing through an exchange traded fund (ETF), fewer have used the same investment approach with their retirement savings.
So, just what is indexing and how can you use it with your super?
What is an index (or benchmark)?
An index is a collection of investment assets that are grouped together to represent all or part of a broad investment market.
There are indexes for almost every asset class, such as Australian and international shares, property and bonds as well as currencies and commodities.
Within each asset class you also invest in indexes covering a subgroup of assets. In the case of shares, this might be industry (such as resources and financials), sector (such as the largest global technology or healthcare companies) and geographic regions (such as the 20 biggest Asian or European companies).
Investment indexes are designed to reflect the value and market performance – both up and down – of the asset class, sector, or industry to which they relate. They are constructed by large international investment companies like Barclays, S&P, Morgan Stanley and Bloomberg.
The performance of well-known indexes (such as the S&P/ASX All Ordinaries, Dow Jones and NASDAQ) is covered daily in the financial media.
Indexing: How does it work?
Indexing is an investment strategy designed to provide exposure to the performance of a specific investment market by tracking the performance of its key index.
To track the index, an investment manager buys assets in the same weighting as they occur in the index they are tracking. The aim is to match the return of the index by investing in the whole index or a representative sample of it.
Indexing is sometimes referred to as passive investing as it involves passively buying the market, rather than trying to actively beat the performance of the market.
What are the pros and cons of indexing?
1. Benefits of indexing
- Better diversification – Investing in all or a representative sample of a market index provides a diversified portfolio and reduces the risk that comes with holding only a small number of assets.
- Reduced volatility – Buying and holding assets over the longer term may reduce volatility and improve your returns.
- Lower cost returns – Picking investment winners is difficult in the long term, so indexing provides a low-cost way to achieve market returns.
- Reduced investment costs – By tracking the index, there are less of the normal transaction and brokerage costs associated with regularly buying and selling assets.
- Lower management fees – Tracking the performance of an index means you are not paying for teams of highly paid ‘star’ investment managers.
- Tax efficiency – With indexing, your after-tax position may be better due to a reduced level of trading and lower CGT obligation.
2. Drawbacks of indexing
- No downside performance – Indexes represent the performance of a market, so if that market declines, its benchmark will too. Active managers may be able to limit this by hedging or moving to cash.
- Over-representation of assets – If an asset becomes overvalued, it carries more weight in the index, but the index manager must still hold the asset.
- No control over the holdings – Indexing requires the manager to hold certain assets to replicate the index, so you have no control over which assets your index manager buys.
- Inability to duplicate some strategies – Indexing is limited to well-established investment styles and sectors. Index funds cannot replicate every investment strategy or style used by active managers.
- No potential for higher returns – Index funds cannot outdo the market the way an actively managed fund can, as their job is to replicate – not exceed – the market’s performance. Active management offers the possibility of higher returns.
How do super funds use indexing strategies?
Indexing is based on the theory that trying to consistently pick investments that will achieve higher returns than the market is impossible. Instead, indexing aims to deliver the same investment return as the benchmark – without the high cost of active management.
Super funds use indexing to maximise the diversification of their investment portfolios and to reduce their investment risk. Buying and holding securities for a long period – rather than regularly trading them – also reduces your fund’s investment costs and helps boost the returns you receive in your super account.
Some super funds blend active and passive investment strategies in a core plus satellite investment approach. This involves investing the core of the fund’s portfolio using index strategies, while the remainder is invested in a series of actively managed satellites the fund hopes will provide members with higher returns.
Which super funds offer indexed investment options?
In addition to using indexed strategies across the fund’s whole portfolio, many large super funds have added indexed options to their menu of investment options.
This means you can choose to invest some or all of your super using an indexed approach – both when you are saving for retirement and when you invest in a super pension after leaving the workforce.
In addition to the reduced investment costs that come with an indexed investment option in your super fund, your investment returns are only taxed at the super capital gains tax (CGT) rate of 15%. This is usually much lower than the normal CGT rate you would pay on capital gains outside super, which can be as high as 45%.
For fund members looking to choose a straightforward and cost-effective investment option, an indexed investment option may be worth considering.
Indexed investment options: What’s on offer?
Like their actively managed cousins, the indexed invested options offered by super funds come in two main forms:
1. Pre-mixed investment options
A pre-mixed indexed investment option is a mix of growth and defensive assets built to perform in line with the return from its pre-set benchmark index over all time periods.
Pre-mixed investment options are usually based on benchmarks such as Balanced, Diversified or High Growth, each of which has a different mix of growth and defensive assets.
Super funds that offer their members the ability to make direct investments usually offer the option to invest in managed index funds and exchange traded funds (ETFs) listed on the ASX.
2. Specific asset classes
An indexed investment option tracking the benchmark index for a specific asset class (such as Australian shares), designed to deliver similar returns to its benchmark index over all time periods.
The index-based asset class investment options offered by super funds usually track assets such as Australian shares, international shares, international fixed interest and property securities.
Who’s offering indexed options?
Many of the major industry and retail super funds offer both their accumulation and pension members indexed investment options.
Among industry funds, for example, AustralianSuper offers an Indexed Diversified option, while HESTA offers an Indexed Balanced Growth option, and LegalSuper and Sunsuper both offer Balanced Index options to members.
Retail super funds such as AMP’s MyNorth, BT Super, Virgin Money and Mercer also offer indexed investment options covering both pre-mixed and asset class portfolios.
Increasingly, super funds (such as Netwealth Super Accelerator, BT Super Invest, ING Living Super, HostPlus Super and Care Super) are offering their members Direct Investment options. These allow you to select and invest directly in ETFs, which are another way to access indexed strategies.
Several new start-ups operating in the Australian investment market (such as Virgin Money, Spaceship and Superhero Super) also offer fund members the opportunity to invest their super using low-cost indexed strategies. These super funds say they offer members the opportunity to invest their super account “the way you want”.
By offering indexed investment strategies, the new entrants can offer lower fees than the actively managed investment options usually provided by larger, more established super funds.
It’s worth noting, however, the investment options offered by these newer super funds usually invest through ETFs or the large indexed managed funds offered by the international specialist index fund managers, such as Vanguard, BlackRock and BetaShares.
In fact, Vanguard has announced plans to open its own super fund in Australia once it receives regulatory approval. The US-based international investment giant (which is the largest provider of index ETFs in Australia), reportedly told the media it plans to provide a super fund emphasising simplicity and transparency “to deliver low-cost, high-quality super”.