Every ASX investor should own an index fund. Here’s why

Index funds are becoming increasingly popular on the ASX. According to fund provider BetaShares, August saw a record $7 billion flow into ASX index funds and exchange-traded funds (ETFs) in Australia, pipping what was a previous record of $6.83 billion in July. Are you one of those investors who put additional cash into an ASX ETF or index fund last month? If you weren’t, let’s talk about why you might want to change that in September.

The ASX is full of ETFs and index funds. More seem to pop up every month, with more than 500 different ETF products now available on the ASX.

Before we get too much further, let’s make an important distinction. One can buy an ETF for almost every investing goal one can think of. Want to invest in oil futures? There’s an ETF for that. Just as there is for buying Korean shares, Japanese stocks, global mining companies, global healthcare companies, banks, defence companies… You name it. ASX investors have never been more spoiled for choice when it comes to ETFs.

Index funds and ETFs on the ASX

What I am talking about today are simple, plain-Jane index funds. These are ETFs that invest in a straightforward, market-wide index that covers every meaningful company in a particular market.

The most obvious examples are, of course, ASX index funds. There are a plethora of such funds available right now for the Australian share market. Most track the S&P/ASX 200 Index (ASX: XJO), which is an index that covers the largest 200 public Australian companies, weighted by market capitalisation (size). A few outsiders opt for the larger S&P/ASX 300 Index (ASX: XKO) instead.

To put it simply, when you buy an index fund that tracks the ASX 200 or the ASX 300, you are buying a small piece of each of those 200 or 300 companies. That market-cap weighting means that the larger companies get a larger allocation in the ETF than the smaller ones. To illustrate, an ASX 200 ETF will (right now anyway) usually allocate about 11.6% of its portfolio to BHP Group Ltd (ASX: BHP), but less than 0.5% to smaller stocks like JB Hi-Fi Ltd (ASX: JBH).

These allocations are readjusted every few months to reflect the companies’ share prices (thus valuations). This means that, over time, the index fund adds to the shares that perform well, and sells down the stocks that fare poorly. This is all done passively, without any input required from the fund’s investors or managers.

In this way, an index fund is guaranteed to match the performance of its ‘market’. After fees, of course. Most investors in Australia who choose to buy and invest in individual ASX shares do so to try and beat the market, that is, get a better return than an ASX index fund. Some succeed, but not many. As we discussed last week, statistics show that the vast majority of investors, even those whose job it is to invest, don’t beat the market over long periods. Those who do are exceptionally skilled, or (more often) are just plain lucky.

Heads you win, tails you don’t lose

That’s why I think almost every ASX investor should be allocating at least some portion of their overall portfolio to index funds. If you enjoy stock picking, and think you have what it takes to beat the market, perhaps an allocation of 30%, 40% or even 50% to index funds is still prudent. That way, up to half of your portfolio will always match the market’s return. If your stock picking is successful, you still get to beat the market overall. If it falls short, your index funds can help ease the burden of that underperformance.

Of course, this won’t suit everyone, and you should always consider your own circumstances and goals before implementing an investing strategy. But at the end of the day, I think most Australians who invest in the share market will be financially better off if they allocate at least some portion of their portfolios to simple, cheap index funds.

The post Every ASX investor should own an index fund. Here’s why appeared first on The Motley Fool Australia.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has recommended BHP Group. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.