So you want to invest in index funds, but where do you start? After all, there are literally hundreds of indices to choose from and many different funds. As with any investment, you need to do some research before you start investing. Then you can go about choosing the right index fund with confidence.
Quick index recap
An index fund acts like a basket of shares, investing in the companies listed in the index it tracks and mirroring the performance of that index.
For example; Kernel’s NZ 20 fund invests in the 20 companies in the S&P/NZX 20 index (think Meridian Energy, Spark, Mainfreight etc). There are no stock picking decisions, very little trading and overall an index fund is low cost.
You can read all about how an index fund works in our earlier blog here.
How to choose the right index fund
With so many options now available it can be overwhelming trying to work out what’s best for you. Here are our top tips of things to look for to find the right index fund for you.
1. What type of investment do you need for your portfolio?
Remember, everyone’s investment goals are different. Therefore, your portfolio should be made up of funds that fit your age, goals and risk tolerance.
If you are seeking long-term growth and don’t need the money in the short term (i.e. you plan to leave your investment untouched for at least 5 years), then you will want an index fund that invests in shares.
If you need more stability, or access to the money in the short term, you will want to include bonds. So the first step is to work how you want to split your investment between growth and defensive portions.
If you are not sure how to go about this, you can start with the five profiles available in the Sorted Kickstarter or talk to a financial advisor. Once you’ve done this, you can filter your investment options down within each category, making it easier to find the right fund for you.
The next decision is what level of exposure to both NZ and global assets you want to include. New Zealand investments have the benefits of tax credits to reduce the tax payable, no complications with foreign exchange and cost less to access. However, many investors want the largest, broader and multiple economy options of foreign investments.
2. Select the right index
One of the great benefits of index funds is their transparency. As an investor, at any time you can see all of the companies each index fund is investing into. You don’t get that with active funds!
But not all index funds are the same and it’s important that you understand what the index invests in, how it invests and where it may sit within your portfolio.
Take time to understand the specific index a fund tracks and select an index strategy that meets the objectives you are trying to achieve. Now you’re well on your way to choosing the right index fund.
3. Keep an eye on the management fees
No matter how you invest, there are going to be fees to facilitate or manage the portfolio. One of the benefits of index funds is their low management fees. This means more of the returns remain in your pocket, rather than with the fund manager.
Management fees will vary depending on what the fund invests in, the size of the fund, and the operations of the fund manager.
There is little point in choosing a fund based on the cheapest fee, if the manager is unable to effectively track the index and produces a worse return than the index.
When comparing, it’s a good idea to look at fund return against the index return for a period of 3 months or more as shorter periods can be impacted by timing differences.
The job of an index fund manager is to give their investors the return of the index, less fees and taxes. For example, if you invested in a fund that tracks the S&P/NZX 50 index and the index went up 10% for the year, if the management fee on the fund was 0.50% you could expect to receive 9.50% return, before tax.
However, there are things that can cause an index fund manager to perform worse than just market return minus fees. For example, if they hold too much cash, their tax structure is inefficient or they make operational errors.
All of these things can eat into the investor returns, meaning that instead of 9.50% you may only receive 9%. This doesn’t sound too bad, but when compounded out over several years it can have a big impact.
Equally, there are things index fund managers can do to improve on how well they track the performance of an index. Often these are technical nuances, like reinvesting the underlying dividends between distribution dates, securities lending or how they trade the underlying stocks at an index rebalance.
As an investor, you want to invest with an index fund manager that puts time, effort and care into how they run the fund. Individually these items are often very small, but when added together they can have a material impact on your returns.
Anytime the return of the index fund deviates from the return of the index, either positive or negative, it is called tracking difference. As the name implies, it is a simple measure of how well the fund manager is tracking the index. One of the first things you want to look at when choosing the right index fund, is the tracking difference.
How do you find the tracking difference?
Some fund managers like Kernel openly publish this figure each month. You can find it in our monthly factsheets via our fund pages. However, not all index fund managers publish this metric.
You can readily calculate it yourself though by comparing the gross index returns vs the after fees, before tax returns of the fund over the same time period. One way to do this is looking at the Fund Update. Each fund is required to publish this on a quarterly basis and there is a standard section in this report that tells investors the fund returns and the index returns.
Here is an example:
By taking the index return and deducting the annual fund return (after fees, before tax) you have the following: 0.36% – (-0.13%) = 0.49% tracking difference.
If the fee on this index fund is lower than 0.49%, then the fund manager has for some reason not tracked the index correctly. Note taxes are excluded because they are personal to the investor, not caused by the manager.
Tracking difference is in essence, an unpublished fee that can eat into your returns. When searching for an index fund and fund manager, look at the tracking difference rather than the published management fee. It could have a far bigger impact on your returns than the management fee.
If a fund is less than 12 months old you will not have this information in the fund update. You can still measure tracking difference by looking at published returns after fees, before tax, and comparing that to the gross index returns. You can do this for any time period that suits: one month, one year, 10 years etc
5. Look at other fees
Generally speaking you want to be investing in funds with no, or low, transaction fees.
While we’ve already talked about the management fees a fund charges, there are a number of other fees that may be hidden or less obvious and they can eat into your returns. Total fees do matter when choosing the right index fund.
Investors can access an index investment through Exchange-Traded Funds (ETF) or unlisted funds. Units in an ETF can be bought and sold, like a share, on a stock exchange. Whereas with an unlisted index fund you will be buying and selling directly with the fund manager.
With an ETF there will usually be a brokerage fee every time you buy or sell, and the price that you pay on the market may not be reflective of the true value of the units.
If you are going to regularly contribute to your investment portfolio, then an unlisted index fund may be the best structure for you because there are often low, or no, transaction fees.
Common transaction fees to consider are:
- Brokerage/transaction fees – these are charges you pay every time you buy or sell an investment listed on a stock exchange, such as units in an ETF or a direct share. Brokerage fees can range from 0.10% to over 1%! You can avoid brokerage fees by investing in unlisted index funds.
- Buy & sell fee – like transaction fees, this is a clip that the fund manager takes every time you buy or sell into a fund. These can range from 0.05% to 0.30%. They can change at any time, so keep an eye out. There are a number of unlisted index fund managers who don’t charge these fees. Reading the Product Disclosure Statement (PDS), or investment documents, is the best way to confirm if there are buy & sell fees.
- Spread – when you buy units in an ETF, there is a difference between the price you pay on the stock exchange, driven by buy and sell demand, and what the actual true value of those units are. This is known as a spread and normally it should be small, around 0.05% or less. However, it can become quite large and is another fee that eats into your returns.
6. Minimise tax
Ugh tax – we know, we know, it’s not exciting but it’s important. So let’s understand the basics. In countries other than New Zealand, the ETF structure can provide tax benefits as they may avoid capital gains taxes.
However in NZ, it’s not so straightforward. An investment fund is typically structured as a portfolio investment entity (PIE). PIE funds calculate tax using your PIR (prescribed investor rate) on just the interest/dividends received, which is capped at 28% rather than the top marginal rate of 33%.
ETFs vs unlisted index funds
There is a key difference to be aware of here. ETFs listed in NZ are taxed as ‘listed PIEs’ with a flat rate of 28%. If you are on a lower PIR rate (likely if you are retired, investing for a child, a charity or through a trust) then you may be paying too much tax if you are investing via an ETF.
At the end of the financial year, you can file a tax return to claim back this tax, but only if you have other taxable income to offset against.
Unfortunately when it comes to tax there isn’t one simple answer. By that we mean there isn’t one fund structure or one scenario that all investors could follow. If your income situation is complicated or unstable, you will need to do a bit more research and potentially seek tax advice. But don’t ignore the importance of this topic.
Here is a brief snapshot of potential tax implications if investing in local assets and international assets:
- NZ tax – In NZ, you typically only pay tax on the income (dividends) from the companies. This is calculated using your own marginal tax rate, up to 33%. However, if you invest in a NZ-based PIE fund, then the tax is paid on your behalf at your PIR. If you invest via an ETF, it defaults to 28%.
- International tax – when you invest into funds or shares overseas, you are exposed to a range of tax implications. In short – there is Foreign Investment Fund tax, withholding tax and tax treaty benefits to consider. If you want to avoid this complexity and/or the cost of a tax accountant, but still want exposure to international markets, you can invest in a NZ-based PIE fund that invests into international markets. The NZ based fund will calculate and pay all the tax.
7. You can have too much diversification
We regularly come across investors who think they are diversified because they have picked a large number of funds. In reality, they may have done the opposite, because many of the funds may hold the same or similar investments.
As a result, the investor becomes concentrated in those investments rather than spreading the risk between asset classes and markets. On the flipside, spreading $10,000 across 1,000 individually purchased companies will create a lot of transaction cost.
Diversification is primarily about asset classes (property, shares, cash, etc.), industry (e.g. IT, Healthcare or Energy) and country. The published fund holdings and current for an index fund will help you to compare how your money is invested.
So let’s recap on choosing the right index fund
The key things to look at when trying to find the right index fund to reach your investment goals:
- Type of investment required: Do you need the long term but fluctuating growth of shares, regular income from bonds or a combination of both? What proportion of New Zealand based investments and overseas investments are you wanting?
- Select the right index: Every index is different and should transparently give you its holdings.
- Know the management fees: As these are often the biggest impact on your return, but…
- Tracking: If the manager is unable to give you the index performance, then the cheapest fee is irrelevant.
- Look for other fees: There may be charges and transaction costs on an ETF that reduce your return on investment.
- Minimize taxes: Know the basics so that you don’t get caught paying too much or cause extra work at year-end.
- Too much diversification: Look at the funds holdings to see what you are actually invested in.
There you have it – the seven, somewhat detailed things you need to consider when picking an index fund. Who said passive investing was boring?
If you have any questions, get in touch with our team. We’d love to hear what indices you love #investmentnerds