07.Indexing pros and cons plus active v index funds
Indexing pros and cons
- Low fees
- Track index returns (before fees) and should beat active fund managers that under-perform the index.
- Diversification. Your risk can be spread across hundreds of shares/companies that comprise the index (on the downside you're fully exposed to that market's risk).
- Low turnover. Because index funds buy and sell shares less frequently than actively managed funds, transaction costs are lower, cutting fees for investors. This can also mean the fund has lower tax liabilities, as capital gains aren't realised as often as with actively managed funds.
- Track index returns. If the index loses value, so will your investment. If Australian shares perform poorly in the future, you could lose significant amounts of money.
- Specific market risk. In the case of an S&P/ASX index fund, for example, you've no diversification away from Australian shares. You've full exposure to that market.
- Underperforms the more successful active managers.
- You'll invest in all companies in the index - even those you may not like or don't think will be profitable.
- Less flexible in market downturn. Index managers can't shift investors' money into safer havens like cash and government bonds, or use other risk-reduction strategies active managers employ.
Active vs index funds
The debate about whether index (‘passive’) or active fund management is ‘better’ has gone on for many years; it’s unlikely that a consensus will ever be reached.
Active and passive fund management have pros and cons and are both valid management styles.
Studies and reports (often sponsored or promoted by index managers), are sometimes used by index managers to make the case for indexing by presenting data to support their argument that index funds outperform average active funds, for example. Another recent study suggests that even when active managers outperform, they’ve difficulty in maintaining this performance in subsequent years.
However, you’d expect active managers to argue that they add value, and the best actively managed funds perform better than index funds. Over the three years to 12 December 2005, for example, the best performing Australian share funds returned around 40% pa (however, these funds are generally more specialised than standard diversified Australian share funds, using gearing or specialising in resource companies). The sector median was around 19% pa, while the index returned around 22% pa over that time.
The problem for investors is picking an active fund that’ll outperform in the future; past performance is not a reliable indicator. Some in the industry say that getting advice from a professional is crucial in picking the right managed funds; however, the cost of this advice — whether fee or commission-based, should be factored into your calculations and decision.
For more info on selecting a managed fund, check out out Managed funds.
This article last reviewed March 2006