Beyond index funds

There are several ways to earn the average market return, but beware varying costs.

Summary: Investors looking for low-cost exposure to the average market return have a range of options. Index funds offer an easy way to make additional investments, while exchange traded funds promise a similar performance but tend to be cheaper. Listed investment companies are also a low-cost managed investment, while investors could also directly purchase the top 20 companies in the index.

Key take-out: Listed investment companies can trade at a discount or a premium to the value of a portfolio. If the chance came to buy listed investment companies AFIC or ARGO at a discount, I would jump at the opportunity.

Key beneficiaries: General investors. Category: Shares.

For many investors their key objective within the stockmarket is achieving average returns. Index funds are the most obvious choice within this approach but there are other avenues you can explore. Today I start by explaining index funds and then outline some very feasible alternatives … just watch those fees.  

An index fund

Investment management company Vanguard has a long history in providing index funds, starting in the US. In Australia the Vanguard Index Australian Shares Fund is available to retail investors with a cost of 0.75% per annum. Compared to a traditional managed fund charging a fee of 1.8% or more, 0.75% is a relatively attractive fee. The fee also falls as the investment size grows. For the amount of the investment above $50,000 it drops to 0.5%, and any above $100,000 it drops to 0.35%.

An index fund like this Vanguard fund provides an easy mechanism for making additional investments (they can usually be made by BPay or Direct Deposit), and will reliably provide the average market return minus the cost of the fund. This, in my mind, is the problem. A fee that starts at 0.75% is significant for an index fund, and might encourage investors to look for lower cost market exposure.

The exchange traded fund

Exchange traded funds (ETFs) promise a similar underlying market performance, just like an index fund. The advantage of ETFs over index funds is that they tend to be cheaper. Vanguard has an Australian Shares Index ETF and the cost is 0.15%, about one-fifth the cost of the equivalent Vanguard retail index fund. As an investment vehicle it does not allow small additional investments as easily as an index fund, as additional purchases have to be made through a broker. That said, with easy access for most investors to cheap brokerage of $15 or less, even additional investments of $1,000 to $2,000 into an ETF are economical. Recent research into ETFs and self-managed super funds by research firm Investment Trends found significant growth in the number of funds using ETFs, with trustees choosing them because of their diversification, access to overseas markets and low cost.

Listed investment companies

Some of Australia’s lowest cost managed investments are listed investment companies (LICs), with AFIC and ARGO both having annual costs of 0.18%. When looking for market returns, it is reasonable to ask how similar the portfolios of AFIC and ARGO are to the underlying index. The following table compares the top 10 investments of ARGO and AFIC with the index. AFIC, ARGO and the index all have exactly the same top six holdings (albeit in slightly different orders), with similarities through the top 10. I have added the 11th biggest company in the index (Rio Tinto) as it is only just outside the top 10. The holdings common to all three portfolios are highlighted.

Table 1: Top 10 holdings


Graph for Beyond index funds

*The eleventh biggest company in the index, Rio Tinto, is also highlighted as it is only just outside the top 10 and is held in ARGO and AFIC.

Naturally the biggest companies in a portfolio have the greatest impact on performance, and given the similarities between the top 10 holdings in these two LICs and the index, it would be reasonable to expect, over time, a market type return. The opportunities and risk of LICs are that the portfolio can trade at either a discount or a premium to the value of the portfolio (its net tangible assets or NTA). 

We have previously looked at the strong return from owning AFIC in the period from January 1, 2004 (see Dividend testing LICs and ETFs), finding a $10,000 investment provided $9,527 in dividend value (cash plus franking credits) over a 10.5-year period while almost doubling in value. This came from buying AFIC at the start of the period at a slight discount to the value of the portfolio at the time.

From a long-term perspective, if the chance came to buy AFIC or ARGO at a discount to NTA, I would jump at that opportunity. The results from buying AFIC just over 10 years ago at a slight discount to NTA have been great, as have the returns for investors who bought ARGO at a discount, an opportunity discussed earlier (see Argo’s golden cargo).

Owning the top 20 companies directly

From an ongoing management fee perspective, the cheapest way to get market exposure is to directly purchase the top companies in the index. This gives the investor ongoing costs of 0%, complete control over the timing of buying and selling of assets and the ability to participating in special situations, like buybacks, exactly as they like.

A downside of this is that while the majority of the index is the top 20 companies, you end up with a portfolio of largely large growth companies. This can be managed by looking to invest in small and value companies alongside the holding of large companies.

Conclusion

As an investor we don’t have to choose one option over another. Directly owned index funds in Australia are not cheap compared to other parts of the world (eg the US and UK), but they do provide the ability to start and investment strategy by easily adding regular investments. Once a more sizeable sum has accumulated an ETF becomes more cost effective, and there are many providers of ETFs in the Australian marketplace (iShares, SPDR and Vanguard, currently the cheapest) to choose from. And, I look forward to any future opportunity to be able to buy any of the low-cost, “old-style” LICs at a discount to the value of its portfolio – which seems to have provided very attractive market exposure for investors who have taken advantage of these opportunities in the past.

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