What are index funds?

Traditionally, if you want to play the stock market, you have to invest in one company at a time – by buying 50 Commonwealth Bank shares, for example, or 100 BHP shares.

However, an index fund is an investment product that lets you invest in multiple companies simultaneously.

Index funds, also known as exchange-traded funds (ETFs), invest in categories of stocks. For example, the Vanguard Australian Shares Index ETF follows the S&P/ASX 300 Index. This index is a collection of 300 of Australia’s largest publicly listed companies, whose combined value represents about 81 per cent of the total value of the Australian Securities Exchange (ASX).

How are index funds structured?

ETFs can be bought and sold, just like individual shares.

So if you buy one unit (or one share) in the Vanguard Australian Shares Index ETF, you’re effectively investing in 300 companies, or 81 per cent of the ASX, at once.

Each index fund is structured according to its own rules. The Vanguard Australian Shares Index ETF, for example, is weighted according to the value of those 300 companies. So if, hypothetically, Commonwealth Bank represented 8.5 per cent of the combined value, then 8.5 per cent of the shares held by the ETF would be Commonwealth Bank shares.

If, in the future, Commonwealth Bank became more valuable and represented 9 per cent of the value of the ETF, then the fund would rebalance itself by buying more Commonwealth Bank shares (and selling shares in other companies).

What are the different types of index funds?

Index funds are commonly based around categories, such as:

• Country – such as a fund that invests in the Australian stock market
• Region – such as a fund that invests in Asian stock markets
• Sector – such as a fund that invests in property
• Size – such as a fund that invests in large companies

What are the pros of index funds?

The reasons why people invest in index funds include:

• Diversification – Invest in a range of companies and sectors, instead of putting all your eggs in one basket
• Conservatism – Invest in the market as a whole, instead of trying to beat the market
• Simplicity – Build a portfolio of dozens or hundreds of companies without having to make dozens or hundreds of transactions

What are the cons of index funds?

The reasons why some people like index funds are the same reasons why others dislike them.

Do you want to beat the market? Well, you won’t be able to do so it if you invest in an index fund that mirrors the market.

Do you believe that some specific companies and sectors are hotter than others? Well, an index fund will force you to combine good apples with bad.

Also, don’t forget that index funds charge fees, which would be especially frustrating if you were convinced you could outperform the fund.