May 1, 2021
Original post: June 2019. Updated: September 2021
A few years ago I wasn’t all that keen on investing in Australian index funds. In fact, at the time I wrote an article on why I preferred LICs over ETFs.
Yet fast forward and now the Vanguard Australian shares index fund (VAS) is the biggest holding in our portfolio.
So what’s changed? Well, my thinking has been evolving over the last couple of years. On index funds, and share investing in general.
This post looks at why my thinking on index funds has changed, the different options for investing in Australian index funds, some of the benefits and what convinced me that indexing is the best option for most people.
As of 2018, we started buying shares in an Australian index fund.
Basically, as the market was falling the LICs we own barely moved. Because this is a common occurrence (LICs regularly trade at premiums or discounts), and since I wanted to take advantage of lower share prices and higher dividend yields, I decided to buy an Aussie index fund instead.
This way, it gives us more opportunity to buy shares at attractive prices, versus holding LICs only. That was the primary reason, but it was also on my mind for other reasons which I’d been thinking about for a while.
The Aussie sharemarket gets a bad rap sometimes for being pretty concentrated. And to some extent, that’s fair.
It was only a few years ago that over 40% of the ASX300 index was in the Financials sector. But today (September 2021), Financials are less than 30% of the ASX 300 index.
Traditionally, some old LICs like Argo and AFIC have made an effort to avoid being too exposed to one sector of the economy. And when you have a Financials sector at over 40% of the market, getting more sector diversification is appealing.
Not to mention, we have a small but growing technology sector, a sizeable number of fast growing small and medium sized companies which become larger parts of the index as time goes on.
But the next thing is what really convinced me of the power of index funds.
Every now and then I learn something that blows my mind. The skew of sharemarket returns is one of those things.
And actually, this factor, more than any other, convinced me of the power of index funds in Australia (and everywhere!).
Nicely summed up by Michael Batnick in this post called “The Skew”:
“It’s not just the fees or the competition, but rather, the simple reason why so many managers fail to beat the benchmark is because so many stocks fail to beat the benchmark. The biggest winners have an outsized impact on the index, and there is a steep price to pay for missing them.”
Batnick sites a study done from 1994-2016…
It shows the performance of the US sharemarket over that time was 7.3% per annum. But if you had missed the top 10% performing stocks each year, your return would drop to 2.9% per annum. And if you missed the top 25% performing stocks, your return would be -5.2% per year.
Another great example of this factor is this post from A Wealth of Common Sense, by Ben Carlson. Ben shows research from Longboard Funds using data from 1989-2015, with the following findings on individual stock performance.
Well, all of the gains in the S&P 500 came from the 20% best performing stocks. Incredible! Not only that, but 40% of all stocks during the period actually had a negative return.
Now, we don’t know if this is always the case. Or if this factor is the same with an Australian index fund. But I do think it’s extremely likely to be an ongoing theme of markets and is a similar story in many countries.
The harsh reality of business is this: many struggle, a few do reasonably well, and some are insanely successful. Essentially, the Pareto Principle, or the 80/20 rule in practice.
Despite the above being a major reason that convinced me to add index funds to our portfolio, there are other positives.
Simplicity. Having one holding which owns the market and knowing you can hold it forever is a pretty powerful concept. There is no decision-making required.
Owning an index fund today which holds the top 300 Australian companies is nice. But by owning the index for the next 50 years, you’re also guaranteed to own the top 300 companies in 2069, whatever they are… (space mining, alien communications, multi-planetary transport, time-travel companies?). That’s even cooler!
Index funds are self-cleansing. An Australian index fund will simply hold the largest companies by market value all the time. As companies grow and shrink, some will rise, others will fall out of the top 300 and are replaced with new, growing companies.
And as industries change over time, your index fund will change to reflect that. So it really is a one-decision investment you can own and accumulate over your lifetime.
Low cost and low turnover. Index funds are the cheapest, most diversified investment you can buy. Lower fees mean more dollars in your pocket as the end investor. And because index funds buy and hold, there is very little selling of shares, meaning they’re very tax efficient too.
We discuss the benefits of indexing in more detail in this podcast: Why Invest in Index Funds?
Here are some of the most popular choices for Aussies wanting to buy index funds which track the ASX 200/300.
This index fund is managed by Vanguard and owns the top 300 companies in Australia. The management fee is 0.10% at the time of writing, and this ETF has been running since 2009.
This index fund is managed by Betashares and owns the top 200 companies in Australia. The management fee is 0.07% (currently the lowest of any option), and this ETF has been running since 2018.
This index fund is managed by BlackRock and owns the top 200 companies in Australia. The management fee is 0.09% and the fund has been running since 2010.
All of the above funds pay dividends on a quarterly basis, and I would consider each of them an excellent choice for investors wanting to invest for the long term in an Aussie index fund.
The reason I chose the Vanguard Australian shares index fund (VAS) over the other options is for the following reasons.
1– VAS tracks the top 300 rather than the top 200. Those extra 100 companies are only a small percentage of the fund today. But as the economy broadens over time, those 100 companies may become a bigger part of the index than they are now. Plus, I figure why not buy the broadest index available?
2– Most index fund providers are profit-motivated (which is fine), but the parent company Vanguard US is essentially a not-for-profit company (by that I mean all profits are returned back to investors in the form of lower costs).
Although Vanguard Australia isn’t the same as this, the fees are still flowing back to the ‘not-for-profit’ Vanguard US. Besides, I fully expect Vanguard and other broad index funds to end up at basically zero fees eventually.
3– Vanguard have a proven track record of indexing over many, many decades – longer than most index fund providers.
4– VAS has also started doing securities lending (letting traders borrow stock to sell – a very common practice that many index managers in the US do as well). This helps the fund earn some income and results in higher returns/lower net fees.
So that’s why I chose VAS. But to be clear, there is nothing wrong with the other low-cost index options in Australia!
After learning more about indexing (especially the skew factor), I have a much greater respect for index funds.
It’s the simplest way to invest for everyday people, and you can be confident that whatever happens over the next 50 years, your index fund will reflect whichever companies are important in Australia at the time.
Don’t get me wrong, I still invest in other things, like LICs and real estate trusts. But index funds will be a large part of our portfolio going forward.
They’re low cost, diversified, tax efficient, and you can comfortably own it and add to it forever!
How do index funds fit into your portfolio? Share your thoughts in the comments.
By the way, if you’re interested in the spreadsheet I use to keep track of my annual dividend income over the years, enter your email below and I’ll send it to you.