Indexes and Index based investments

20 Nov 2012

By Shadforth Financial Group

In the media you often hear the term Index or Index Funds, they are simply 'baskets' of stocks, bonds or other investments that are designed to replicate an investment market or sector.

The main indices that you would usually hear about are:

Common indexes Definition of the index
UBS Composite Bond Index Represents the market value weighted accumulation index of the UBS Government, Semi-Government, Corporate and Asset Backed Bond Indices. The return represents the return of these combined indices
ASX200 – A-REIT Property Index This index contains the listed vehicles classified as real estate investment trusts. They own property and derive income from rental returns.
ASX200 Accumulation Index This is a broad market index comprising of the top 200 Australian domiciled companies by capitalisation (i.e. market size)

MCSI World Index ex-Australia

This index represents 1500 stocks from around the world in 23 countries.
Dow Jones Index This index measures the market prices of 30 large industrial blue chip companies on the New York Stock Exchange
FTSE (Pronounced Footsie) The Financial Times Stock Exchange Index comprises the largest 100 public companies listed on the London Stock Exchange.
Hang Sang Index This index comprises the 45 largest companies by market capitalisation on the Hong Kong Stock market.
Nasdaq Composite Index This index consists of more than 3,000 technology based companies on the NASDAQ stock exchange in the United States.
Nikkei Dow Index This is the Japanese Share Price Index and covers the largest 225 shares listed on the Tokyo Stock Exchange.
S & P 500 This consists of the 500 largest stocks in the United States based upon their market size, liquidity and sector.

How is an Index calculated?

Indexes are usually calculated on the basis of price and market capitalisation. In simple terms this means that a company's contribution to an index depends on how large they are, which is usually referred to as their market capitalisation. This is calculated by multiplying their share price with the number of shares on issue. For example BHP is approximately 15% of the Australian share market.

What is an Index Fund or an Exchange Traded Fund?

An index fund is simply a managed fund that attempts to replicate the underlying investments in the index and as a consequence the performance of the index. On the other hand an exchange traded fund is a similar investment vehicle but this is listed on a recognized trading exchange such as the Australian Stock Exchange. The latter can usually be sold or purchased immediately due to the liquidity of the listed markets.

What are the advantages and disadvantages?

As with any investment approach, there are advantages and disadvantages. The advantages of an index based investment include: Lower fees, as the investment decisions are generally based on the composition of the index and not the investments selected by a research team. Lower portfolio turnover leading to lower fees, as the portfolio only needs to be adjusted when the index changes. Tax efficient, as the portfolio is often a "buy and hold" strategy rather than frequent trading which can potentially cause capital gains tax issues. Minimises risk of an investment manager making poor investment decisions as your return will always replicate the index. Despite "noises" to the contrary, most active fund managers will under perform the index over the long term. Automatic re-weighting occurs as poorly performing stocks are removed from the index and those stocks that perform well are moved into the index.

The main disadvantage of an index based investment is that as you have a portfolio that simply replicates the index, you can't outperform the index and a 1-2% difference over the long term can be significant.

Final word 

In summary index funds are designed to generate market returns, offer low costs and require minimal involvement from you as investor. As slightly different approaches produce different outcomes, it is important that you get advice about how to design and implement an investment strategy that is suitable for you, please contact us for further information and assistance.

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