So you’ve heard all about Index funds and want to get serious about investing your money but you have no idea where to start. This is where we come in! Index funds are about as easy and ‘set and forget’ as you can find and you could do a lot worse than investing your money into a solid index fund.

Firstly we need to distinguish between ETF’s and Actively Managed Index Funds.

  • ETF stands for exchange traded funds, they’re bought on the ASX just like any other stock and generally hold a basket of individual funds, rolled into one easy-to-buy fund.
  • Index or Passive funds simply aim to track an index like the ASX 200 or the S&P 500 without any input from a fund manager.
  • Actively Managed funds are run by a fund manager who dynamically holds, buys and sells as he sees fit. These typically charge higher fees.

Now that you are able to follow, let’s take a look into index funds, whether they might fit your investment criteria and how fees could eat into your returns.

Think about your objectives

As someone that is looking into investing in Index Funds, you should really be thinking about it as a long term investment. On average, the stock market will generate positive returns every 7/10 years, meaning that if you’re taking a long term approach and investing in a quality fund, the odds of you making a profit are quite high.

Conversely, if you’re looking at parking money in index funds as a short term option and you face some unlucky timing, you may be investing in one of the 3/10 years where it delivers negative returns. In that instance, you would’ve been better off holding your money in a savings account providing you 3% guaranteed returns.

Each financial situation is going to be different, but I would suggest that anyone looking to invest for a period of 10 years or more should consider index funds, whereas anyone looking for a short term park should consider a savings account or term deposit. Keep in mind that you’ll be paying capital gains tax (CGT) when selling your index funds, which a savings account wouldn’t incur.

Four components of Index Fund Investing

There are four components of Index Funds that you need to know about before you begin;

  1. The name of the ETF or Managed fund you’re investing in
    • Firstly you need to work out what you plan to invest in. Index fund offerings from Vanguard, Blackrock and BetaShares are highly popular in this area and offer a plethora of different options. You will want to check a fund’s prior performance, fees and investment methodology which can be found on their respective websites. Tickers like VDHG, VAS, VGS are all examples of the name of a fund.
  2. Fees charged by the respective fund
    • Fees are one way to make a good return look mediocre real quick. Over the last 15 years, 92.2% of large-cap ($10bn+) actively managed funds in the US have lagged an index fund that simply tracks the S&P 500 and a large reason why, is due to fees. Assuming a 7.50% return, investing $2k a month over 30 years and paying an extra 0.50% in fees a year, thereby reducing your return to 7.00%, will reduce your total return by a whopping $214,527.
  3. Which broker to use or whether to buy direct
    • The beauty of ETF’s is that they can be bought on the ASX just like you were buying some BHP or TLS shares. Going through a managed fund, you can buy directly through them using their interface. No matter which broker you choose, you need to ensure you choose one with low brokerage fees as our last example showed.
  4. Dividend reinvestment
    • Albert Einstein once called Compound Interest the eighth wonder of the world and a large part of that is Dividend reinvestment. When you buy shares, you’ll get mailed a form with the option to automatically reinvest all dividends straight back into the fund, rather than them hitting your bank account. It’s a no-brainer and one of the biggest drivers of compound interest.

Pros and Cons of ETF’s v Managed Funds

There are pros and cons of investing in both ETF’s and Managed Funds, each to be considered before diving into either option.

ETF’s

  • Can be easily bought on the ASX like any other stock
  • Generally have lower fees than managed funds
  • Can buy at intra-day prices
  • Get charged brokerage fees on every purchase

Managed Funds

  • Can be bought automatically each week with BPAY
  • Generally have higher fees than ETF’s due to buy/sell spread, indirect costs etc.
  • Only bought at the closing price at the end of the day
  • Wholesale funds have large minimum buy amounts

Fees Comparison

Here’s an example of a Vanguard VDHG fund bought through an ETF and bought as a Retail Index fund. MER stands for Management Expense Ratio, a.k.a fees.

InvestedETF 0.27% MERRetail Fund 0.90% MER
$1000$3$9
$5000$14$45
$10,000$27$90
$15,000$41$135
$20,000$54$180
$30,000$81$270
$40,000$108$360
$50,000$135$450
$75,000$203$600*
$100,000$270$750*

*Please note that as the balance of your Retail fund increases the costs decrease.  Your first $50K has a fee of 0.90%, the next 50K 0.60% and anything over 100K will pay 0.35%.

It’s worth mentioning the wholesale fund, which is the same as the retail fund, except you need a minimum initial investment of $500k and $5k for additional investments (Many people have said Vanguard will allow you into the wholesale fund if you can deposit $100k upfront). The wholesale fund charges a 0.29% fee as opposed to the tiered retail fund costs.

This comes at the ‘inconvenience’ of needing to buy parcels of the ETF each month/year etc. instead of the automatic BPAY payments of the retail/wholesale fund.

Choosing a broker

Choosing to invest via an ETF or retail/wholesale fund will determine how you approach which broker to go with. If you’re investing through a retail/wholesale fund then you will invest directly through the company itself, whether that’s Vanguard, Blackrock etc. You’ll sign up to an account through them and have a web interface to see your holdings, tax implications etc.

ETF’s are bought on the ASX and in order to buy, you’ll need to go through a broker and incur brokerage fees with each purchase. I’m not going to go in-depth here on which broker to choose as I’ve previously written an extensive guide on brokers with the lowest fees, but I will tell you that you should consider only low cost brokers.

If you’re paying more than $12 a trade, you’re probably paying too much. The only advantage of using your bank as a broker is that you can see your savings accounts, trading account etc. all from the one screen.

Compound Interest

Fortunes are made from compound interest. At the start of your investing journey you’ll be investing a fixed amount and be getting a lowly amount of interest. However over time something amazing happens.. Eventually the amount of interest you make on investments dwarfs your fixed amount and your holdings start to grow at a dramatic rate.

Let’s take the example of Saver Sally. Sally is a young 25 year old who just finished a Marketing degree and has landed herself a grad role paying $65k, she’s determined to be successful and has decided she’ll put away $20k a year into index funds (or $1666 a month). Whilst at uni she had a part time job and managed to save up $30k. Of this, she puts $20k into an index fund to kickstart it.

Index Fund growth with Compound Interest over 30 yearsAssuming the historic stock market averages of 7% continue into the future, you can see that even though over the course of 30 years Sally invests $619,760, she’s actually sitting on $2,194,802 because of compounding interest. You can see towards the later years that the compound interest really takes off like a rocket and Sally actually makes $150k just in interest, in year 30.

Keep in mind that’s a 30 year investment. At 55, Sally isn’t even old enough to access her super, nor is she at the retirement age. If we were to extend that graph out another 10 years to 65, Sally’s money would more than double and be worth a whopping $4,699,167.

Now do you see where Albert Einstein was coming from?

Posted by Marcus Bancroft

Marcus is a Finance writer and the founder of Financially Frugal. He started blogging to help everyday Aussies save more and retire early. In his spare time, Marcus enjoys bodyboarding at Maroubra beach, playing team sports and enjoying knock-off Nespresso pods.

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