To Index or not to Index

July 5th, 2007

As the new financial year rolls around, I’m giving some thought as to how invest my money. I’ve got a mortgage, which means that my investment portfolio (such as it is) is pretty heavily weighted towards property. So I’d ideally like to put some money into the stock market.

As I see it, I’ve got three options:

  1. Put my money into shares directly.

  2. Put my money into a mutual fund.

  3. Put my money into an index fund.

The first option isn’t that attractive for a couple of reasons. Firstly, I don’t have that much to invest, so I won’t be able to get many stocks. So I’d have to be lucky (DJS, I’m looking at you here) to get decent returns at all.

The mutual fund option looks a bit better. There are a lot of options, and I’d be able to invest only a small amount of money at first. But there are two big draw backs:

  • Decent ‘actively managed’ funds charge very high fees, and even then often require large entrance costs. Which means I’d be stuck with the lower tier of funds.

  • Even the good managed funds can’t beat the market: the evidence suggests that pretty much no firms are able to consistently provide higher returns than the market index (e.g. S&P ASX 200). For instance, see Malkiel (1995).

(The other smaller problem is that almost all of them invest in property to some degree, and I don’t want more property investment in my portfolio)

So that pretty much leaves me inexorably with an index fund. An index fund takes shares that give the same return as an index like the ASX200 (usually a pretty substantial subset o the whole index). So by definition the return on the fund is the same as the market. And as an added bonus, index funds tend to be really cheap: about 1% cost of management, compared to over 4% for some mutual funds.

This is pretty much the advice of experienced market analyst Henry Blodget too, who’s written a great book on share investing. I just need to get a copy rather than just reading the free excerpts…