We’re pleased to share this five-part series on investment by one of our Directors, Paul Reilly. Paul has had a long-standing career providing financial advice and in this series digs into some important investment principles to increase your understanding of sound investment.

EXPLORING INVESTMENTS: ARTICLE 1- INDEX FUNDS VS. MANAGED FUNDS

If you’re considering where best to invest your money, you’ve likely heard the debate between index funds vs. managed funds.

Let’s explore the difference between index funds vs. managed funds, the pros and cons of each, and discuss what we believe is the best investment strategy.

Index Funds

An index fund is also known as an index-based investment strategy or a “passive” investment strategy.

An index fund is defined as:

A managed fund with a portfolio constructed to match or track the return before fees of a particular market index.

In Australia, it’s common for an index fund to track the Australian Securities Exchange (ASX) 200.

There has been a dominant trend over the last few years towards passive investment strategies. By investing in index funds, people aren’t trying to outperform the index; they’re trying to invest in the index for a very low cost.

Managed Funds

Managed or “active” funds are built by investment managers who make choices on investments based on the investment strategies of the fund.

A managed fund is defined as:

A fund that is managed by an individual or committee, which has responsibility for decisions to buy or sell individual stocks or bonds.

During times of market volatility, managed funds may be a better option. Markets are also cyclical, so while an index fund may be performing well, that could shift. Past performance doesn’t always guarantee future returns.

Managed funds are not all the same, however. Managed funds can be single asset or mixed asset, and within each category are several different kinds of investments.

Pros and Cons of an Index Fund

The benchmark index in Australia is generally the ASX 200, which is the 200 biggest companies on the stock exchange, as measured by the market capitalisation.

Market capitalisation is simply the total value of the company, which is the number of shares on issue multiplied by the share price.

So, with a market capitalisation weighted index, you invest the most in the biggest companies. If one company represents 10% of the market capitalisation of the index, then 10% of your money will be in that company.

The positive thing about indexing is that there is a relentless focus on reducing the costs of investment management, which has been positive for investors across the board. In the past, too many fund managers were charging huge fees to just track the index. Thankfully, that has changed.

Another example of creating lower costs are to include performance fees with your investment manager. This would typically occur in a managed fund investment. For instance, your adviser with Financial Framework, would receive a low base fee along with performance fees. So if your investments perform well the adviser receives a bonus and there is always an incentive to do well even during volatile times. That means, that if things aren’t outperforming the market, costs are low for the investor as well.

The downside of an index fund is that because of the way the market capitalisation weighted index is constructed, you always have the most investment in a company or a sector when it’s at its most expensive.

That makes market capitalisation weighted indexes an inefficient way of determining what stocks to buy and how much to invest in each.

As well, the Australian market is extremely concentrated in just a couple of sectors. If you are invested in the index, half of your money is in financials and resources companies, and one of the fundamental tenets of good investing is diversification.

If you’re investing in the Australian index you’re simply not as diversified as you should be.

A More Balanced Approach To Index and Managed Funds

At Financial Framework, we believe that a mixture of index and managed funds will meet a client’s need for investment at a reasonable cost and diversification.

Let’s explore why.

We have a core and satellite approach in the consolidated equities portfolio. Half of the money is invested in each side. The first half is a core, in which we invest in the top 100 companies on the market in a systematic or rules-based fashion.

The satellite component provides an overlay where we’re really trying to understand the business, the quality of management, and the business prospects over the long term.

Our model portfolios have an exposure to both index and managed investments. The decision on what weighting we allocated to each is based on several factors. This could include managing the overall cost, but more importantly we make the decision based on a top-down approach.

This allows us to take into account Macro factors including current market, economic conditions and the stage of the market cycle. We can then make a decision that, given those factors, which investments provide our clients with the best potential to reach their investment objectives with an acceptable level of risk.

The end result would generally be a range of core index funds and a number of actively managed satellite funds.

Final Thoughts

At Financial Framework we believe that we can best meet our clients needs by investing in a range of index and managed investments. The weighting towards either solution is based on significant research and monitoring. We believe that by adopting this principle we can better meet our clients investment objectives whilst taking into account the need for diversity and acceptable levels of risk.

Contact us today to find out more.