This article was published on 3 May 2005. Some information may be out of date.

Index funds still the best, despite tax changes

An ice cream is still delicious without the chocolate dip. The same goes for index share funds.

Since they made an appearance in New Zealand in the late 1990s, these funds have had a tax advantage over the other type of share funds, called active funds.

It seems likely that the tax advantage will be removed soon. But even if it goes, I still think index funds are best.

What are they? An index fund invests in all the shares in a share market index, such as the NZSX50 or America’s S&P 500.

Indexes measure the performance of a share market — although often they are made up of the larger shares in a market, so more specifically they measure the performance of that portion of the market.

And an investment in an index fund will perform almost as well as the index. I say “almost” because it costs money to run a fund, which is reflected in fees charged to investors.

The fees on an index funds, however, are lower than on active share funds. That’s because active funds must pay financial whizzes to research which shares to buy and sell. Also, active funds trade more frequently than index funds, so they pay more transactions costs.

The difference in fees has a big effect on returns over a long period — and investing in any share fund should be a long-term proposition.

For example, if you invest $100 a month over 20 years in an index fund, your return after fees might average, say, 7 per cent. Your total investment would come to $50,750.

The same investment in an active fund might bring you 5.5 per cent a year, or $42,900 over the whole period. (For other examples, use the regular saving calculator on www.sorted.org.nz)

Okay, you might be saying, but if an active fund performs better than an index fund, that could more than make up for the higher fees.

Certainly all the active fund managers say they perform better than market indexes. But how can they all?

As main players in the share market, their average performance must be about the same as the market average. In any given year, only half will be above average, before fees. After fees, it will be fewer than half. And over time, different active funds do better than average in different years.

Over ten years or so, only a few active funds produce returns, after fees, that are higher than the relevant index.

If we knew in advance which ones would do that, we’d all invest in those. But we don’t.

“Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 per cent to 90 per cent of managers fail to match their benchmark,” says Jack Meyer, the remarkably successful manager of a US pension fund.

He’s speaking about the US, but New Zealand is surely similar.

Asked for advice for investors, Meyer replies, “First, get diversified. Come up with a portfolio that covers a lot of asset classes. Second, you want to keep your fees low. That means avoiding the most hyped but expensive funds, in favour of low-cost index funds. No doubt about it. And finally, invest for the long term.”

I couldn’t agree more. And nor, I’m sure, would John Bogle, founder of the Vanguard Group, which manages many huge US index funds,

“Not nearly enough individual investors have yet come to accept the extraordinary value that indexing offers,” he says.

A broad market index fund “is the greatest medium for long-term investing ever designed by the mind of man.”

Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.