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For small investors, the big issue is how to get optimum results when diversifying.

For small investors, the big issue is how to get optimum results when diversifying.

Australian share prices are up more than 5 per cent this year and, who knows, it may be the start of a sustained recovery. But there's also the possibility that the market could continue to move sideways, as it has done since the end of 2009.

Market-watchers are not expecting the Australian sharemarket to dip substantially from here, which means the risk of investing now is probably lower than it has been for a long time.

So for those who believe the market has bottomed, this is a good time to get back in.

The question for many, though, is how to achieve diversification with limited funds. One answer is to look at fund managers who do precisely that.

An Australian shares fund will typically hold a spread of 30 to 60 stocks with the promise of outperforming the market over the long term and charge up to 2 per cent a year.

But the trouble for investors is that few managers are able to consistently beat the market once their fees are taken into account.

Morningstar data shows that in the 10 years to February 29, 2012, only 61 out of 173 actively managed, large-company Australian shares funds outperformed the S&P/ASX 200 Index after fees, or 35.26 per cent of funds.

That's for the large-company shares funds favoured by people who are invested in managed funds. Managers tend to do better in small caps. In the 10 years to February 29, 38 out of 43 small-cap Australian shares funds outperformed the Small Ordinaries Index after fees, or 88.37 per cent.

But the small companies are generally riskier, or more volatile, than large companies. Sharemarket investors would want most of their exposure in large companies that pay more reliable dividends and perhaps use small companies to spice up returns.

That's why for many investors a better option is to "buy the market" by investing in some type of low-cost index fund that replicates or mirrors the returns of the market. Having made the decision to index-invest, the next decision is how to buy the market.

The most popular way has been through managed funds.

The fees on Vanguard's Index Australian Shares Fund - a managed fund that tracks the S&P/ASX 300 - are 0.75 per cent on the first $50,000 and less on subsequent amounts.

The fund requires an initial minimum amount of $5000.

Vanguard and other providers have created new types of listed funds called exchange traded funds (ETFs). These are index trackers that are listed on the Australian sharemarket and can be bought and sold like any other shares. ETFs are available that track all sorts of sharemarkets and sectors.

An ETF's price matches the performance of the market it is tracking.

The director of intermediary sales at the ETF provider iShares Australia, Tom Keenan, says ETFs are a "cost-effective and easy way to get access to the market". An Australian investor may hold stocks that they are not going to sell.

"What an ETF allows them to do is to diversify that portfolio," he says.

Morningstar says the fees on ETFs that mirror the performance of the Australian sharemarket range between 0.15 per cent and 0.25 per cent a year.

ETFs have their drawbacks.

Unlike managed funds, where investors can make regular contributions, ETFs incur brokerage costs each time they are bought and sold.

That means investors may be better off investing in an ETF, for example, each quarter, rather than buying more shares in an ETF more frequently and incurring transactions costs.

There are ETFs that track high-dividend-yielding stocks and ones that track the smaller listed Australian companies. More recently, ETF providers have launched income ETFs that track fixed-interest indices.

But a typical small investor who already holds some of the big stocks such as the banks and Telstra may

not be getting much further diversification by adding an index

fund or index ETF.

These investors could think about adding diversification to their portfolio by investing in an ETF or managed fund that tracks the returns of global shares.

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