Index investing a considered a lower cost way to diversify your portfolio, but it’s worth noting that these kinds of funds can also have an impact on your other share investments.
Many big superannuation and investment fund managers follow strict investing criteria, which is often based around investing in stocks within a certain stock market index.
So, depending on their investment criteria and style, they might have a certain percentage of the portfolio in the top 200 companies; or mirroring the financial or tech indexes; or in the small caps index.
That means changes in the makeup of those indexes will impact the value of a company, depending on whether they are in or out of a certain index.
How an index influences stock values
Companies in an index will automatically go into a lot of investment funds, which creates demand and pushes up prices. Likewise, if a company drops out of an index and is replaced by another stock, investment managers will have to switch out of that stock, which lifts selling pressure which can lead to price falls.
The make-up of major stock exchange indexes are constantly under review. For example, on 19 September these companies will be added to the ASX 200 index: Capricorn Metals; Charter Hall Social Infrastructure REIT; John Lyng Group; Karoon Energy; Smartgroup; Spark New Zealand; and retailer Lovisa.
At the same time, these companies will drop out of the ASX 200: Zip; PointsBet; City Chic Collective; Clinuvel Pharmaceuticals; and Janus Henderson.
Benefits of index investing
An index fund is a type of mutual fund or exchange-traded fund (ETF). It’s a bundle of securities that track the performance of a market index such as the ASX 200. There are a number of reasons why you might add index investing to your portfolio.
1. Lower costs
Index investing general has lower costs than other types of investment funds as management fees are generally lower. They’re also easier to buy and sell, with minimal transaction costs.
When you invest in an index, your portfolio is instantly diversified. For example, if you invest in the ASX 200 index fund, your portfolio would hold 200 different stocks. While each of these stocks would see performance fluctuation over time, by investing in an index fund the value of your portfolio isn’t reliant on the fortunes of any one company held in the index.
For example, in one $500 investment you could buy into an ETF that invests in everything from Australian shares, global shares, fixed income, debt and foreign currencies to commodities and metals.
ASIC guidelines requires ETFs and managed funds to publish, on a daily basis, the full portfolio of the exchange traded product’s holdings. This daily publication of the net asset value of index funds makes pricing more transparent than some other types of investments.
Potential risks of index investing
Any investment carries risk, but index investing is considered a ‘lower risk’ investment. However, that’s not to say that there are no risks. The two biggest risks to consider before you leap in are volatility and timing.
I touched on this above where I mentioned the affect on stocks when companies come in and out of indexes. In addition, indexes are exposed to general market risk and also risk in a particular sector. According to research from S&P Global, the most volatile market sectors during the 2010s (the period between 31 Dec 2009 and 31 Dec 2019) were those most impacted by rapid changes in oil prices. We can assume nothing has changed in the years since.
The sectors most affected were energy, commodities, financial, technology, consumer discretionary, communication, healthcare and utilities. Seeing utilities on this list is noteworthy, given that historically utilities has been considered a ‘safer’ sector.
Many financial advisers see the consumer staples sector as being lower volatility with strong returns. This sector includes companies that produce the essential products we use every day, like food, beverages and household items.
Due to market cycles, some index sectors have a higher degree of risk when the overall sharemarket is set for a strong reaction up or down. Managing timing risk for index investing is no different to any other sharemarket investing. You need to understand market cycles and not let your emotions make your investment decisions.
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