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What is an index fund and how does it work?

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An index fund is a type of mutual fund whose holdings are structured to track a particular financial market. In order to reflect the collective performance of the companies in that market, the funds try to follow the benchmark by buying stocks of every company listed on the chosen index.

One of the most commonly followed indexes is the S&P 500 which measures the stock performance of 500 large companies listed on United States Stock Exchanges. Here, we have the S&P/NZX 50 index which, not unlike the S&P 500, measures the performance of the 50 largest stocks trading on the New Zealand Stock Exchange. The performance of this particular index is represented by the combined performance of the 50 companies listed.

How index investing works

Index investing is one of the most common forms of passive fund management. Instead of a fund portfolio manager actively picking stocks, index fund managers build a portfolio whose underlying investments imitate the companies in the specific index they are following. These funds follow their benchmark index regardless of the state of the markets rather than actively manage their underlying investments to try beat or time the market. Because of this, index funds cannot outperform the market.

Benefits of index fund investing

One of the biggest advantages is that index funds have significantly lower management expense ratios compared to their actively managed counterparts. Index funds track a target benchmark or index, so they avoid constantly having to buy and sell stocks. In return, they have lower operating expenses and lower management fees compared to other funds with an active management style.

Warren Buffet thinks that index funds are the best way for the average everyday investor to grow their money overtime. It is an excellent approach to achieve diversification in your investment portfolio as you are exposed to all the stocks in an index. While index funds are vulnerable to market swings and volatility, they have strong long-term returns which make them ideal for long-term investing.

Passive KiwiSaver fund

Your KiwiSaver fund may be passively managed, while some may have an active management style or even a mixed management style. There is an ongoing debate as to which management style is superior. Some Kiwis prefer to invest their money in a passively managed KiwiSaver fund due to the lower fees, while some think that the higher fees are worth it and prefer to be in an actively managed KiwiSaver fund. However, a report from the FMA shows that there isn’t a significant link between higher fees and higher returns. This could always change in the future due to the FMA proposing to monitor this more closely.

While index fund investing or investing in passive funds may seem great, there are a lot of things to consider before deciding to invest your money, especially in KiwiSaver. While it’s not always guaranteed, active KiwiSaver funds would allow your account to generate more returns than passive KiwiSaver funds who are tracking an index. As we saw from the shift of BNZ’s KiwiSaver scheme into a more passive approach, along with AMP’s KiwiSaver scheme, passively managed funds are becoming more popular.

What is best suited for you?

Performance and fees are important to look at, but they are not the only things you should base your investment decision on. Important factors such as your situation, financial goals, investment timeframe, and volatility tolerance need to be considered to ensure that you will be making an informed and optimal choice.

National Capital can help you create a KiwiSaver investment plan based on those important factors and thus determine which management style and fund type will be the most suitable for you. Take our KiwiSaver HealthCheck to get personalised professional advice from one of our Authorised Financial Advisors to be more confident in your KiwiSaver investment choices.

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With a goal in mind and a clear investment plan, both passively and actively managed KiwiSaver funds can get you there. But which one is more suitable for you?
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