ETFs and Index Investing explained

Indexes are not a recent invention and although some indexes have been calculated for 100 years, index investing is much newer, at about 50 years old. Through the development of the vehicle known as the Exchange Traded Fund (ETF), an investor can get exposure to potentially hundreds of securities in an index with the purchase of just one Exchange Traded Fund (ETF). 

Indexing has evolved so that investors can find an ETF for not just a particular exposure, but also a more specific objective or trend. For these reasons, index ETFs have revolutionised how investors can access markets, build portfolios, and achieve their investment goals.

What Is an Index? 

Indexes are not specific to investing and are a measurement or indicator that can be made for almost anything. In investing, an index is used to represent and measure the performance of securities within a defined market, asset class, sector, or investment strategy that make up funds such as ETFs. Indexes are also valuable benchmarks for investors.

It can be helpful to think of an index as a recipe. All indexes have some rules or criteria to determine their “recipe” to achieve the objective of replicating the performance of a specific market segment. For example, the recipe of an index that seeks to measure the performance of US large cap companies would only include those companies that are incorporated in the U.S. and are above a certain size. Companies that meet those requirements will be eligible for inclusion while those that do not, would be excluded. The S&P 500 is a commonly referenced index which consists of 500 large U.S. companies.

Indexes can also get more granular, for example the S&P Global 100 index which is designed to measure the performance of 100 multi-national, blue-chip companies of major importance in global equity markets.

Who determines the recipe of these indexes? It is the role of index providers, like MSCI and S&P Dow Jones Indices, to construct and monitor a wide variety of indexes. Each provider uses a unique, rules-based methodology to build their indexes. 

Indexing has evolved now beyond well-known, traditional approaches. Advancements in technology and the addition of big data, have allowed indexing to delve into more precise and more targeted exposures. Indexing began in equities but has grown to encompass much more, including all major asset classes, such as fixed income, currencies, commodities, and real estate.

What Is Index Investing?

Index investing or indexing is a style of investing that has grown alongside technology.  Indexes are not directly investable — investors can gain exposure to indexes through investment vehicles such as index-tracking mutual funds or exchange traded funds ETFs.

An investor can build a portfolio by selecting an index to follow.  Replicating an index can be challenging to do on your own. For example, if you want to build a portfolio that includes all the stocks in the S&P 500 at their respective weights, this would mean finding the list of stocks, and then buying all of them at the same proportions, which would require over 500 trades. And you’re not done there. Those constituents change on a pre-set schedule, which is called a rebalance. In short, for an investor to replicate an index is complicated and expensive. 

Fifty years ago, the first investible index product was created by a predecessor firm of BlackRock, allowing investors to capture the performance of an entire index with a single purchase. These are commonly known today as mutual funds and exchange-traded funds or ETFs. 

What are index ETFs?

An ETF is a diversified collection of assets (like a managed fund) that trades on an exchange (like a share) and aims to track the performance of a specific index. 

Index ETFs offer investors diversification by giving access to potentially hundreds of securities, sometimes even thousands, in a single purchase.  Investors may be drawn to index ETFs as they are typically low-cost, meaning you can pocket more of your investment profits. 

What’s the difference between an index provider and an index fund manager?

Fund managers like BlackRock manage funds, not indexes. Index providers license their indexes to asset managers and other financial institutions for a variety of uses, including benchmarking investments. Index fund managers outline their investment objectives and determine which index benchmarks will best align with those objectives — and, ultimately, the needs of investors.

Although index investing is frequently referred to as “passive” investing, index fund management is a hands-on process. BlackRock Portfolio Managers (PMs) and index research teams leverage their deep portfolio expertise and investment skills to consistently seek fund performance outcomes that align with index performance.

How to approach Index Investing

How you approach index investing may vary depending on your financial position and financial goals. The first step to building any portfolio is to understand your objectives, preferences, and risk tolerance, as these considerations should fundamentally shape overall asset allocation and subsequent investment exposures.   

You can select products and indexes based on specific goals such as seeking income, maintaining liquidity, minimising sensitivity to market swings or aiming to maximise growth. Depending on your financial goals, a global multi-asset ETF could be a simple cost-effective solution. As an example, IGRO (iShares High Growth ESG ETF) and IBAL (iShares Balanced ESG ETF) provide investors a choice of two ready built portfolios designed to invest with simplicity. Each portfolio provides exposure to a diversified portfolio of global stocks and bonds with over 7,000 securities. 

Investors who want to take a more customised approach might be attracted to buying individual ETF building blocks to achieve their goals. Investors may want to consider starting with domestic equity exposures, such as IOZ (iShares Core S&P/ASX 200 ETF), which tracks the ASX200 and adding international exposures to diversify their portfolios such as IVV (iShares S&P 500 ETF) or IJR (iShares S&P Small-Cap ETF), which track indexes that include securities depending on their market cap weighting. Small-cap stocks tend to be riskier than large-cap stocks but have the potential for higher growth.  Investors may also want to consider diversifying their portfolios with bond ETFs to help offset stock market fluctuations. 

Index ETFs have revolutionised how people invest and democratised the investment industry in the process. Investors can capture the performance of an entire index with a single purchase with the added benefit that they are portfolios managed by investment professionals who have resources at their disposal that most regular investors don’t. 

Visit www.blackrock.com/au/ishares to view information that you should read and consider carefully before investing. Investing involves risk, including possible loss of principal.

FOOTNOTES

iShares High Growth ESG ETF (IGRO): This product is likely to be appropriate for a consumer who is seeking capital growth and/or income distribution, using the product for a whole portfolio solution or less, with a minimum investment timeframe of 5 years, and with a medium to high risk/return profile.

iShares Balanced ESG ETF (IBAL): This product is likely to be appropriate for a consumer who is seeking capital growth, capital preservation and/or income distribution, using the product for a whole portfolio solution or less, with a minimum investment timeframe of 5 years, and with a medium to high risk/return profile.

iShares Core S&P/ASX 200 ETF (IOZ): This product is likely to be appropriate for a consumer who is seeking capital growth and/or income distribution, using the product for a core component of their portfolio or less, with a minimum investment timeframe of 5 years, and with a medium to high risk/return profile.

iShares S&P 500 ETF (IVV): This product is likely to be appropriate for a consumer who is seeking capital growth and/or income distribution, using the product for a core component of their portfolio or less, with a minimum investment timeframe of 5 years, and with a medium to high risk/return profile.

iShares S&P Small-Cap ETF (IJR): This product is likely to be appropriate for a consumer who is seeking capital growth and/or income distribution, using the product for a core component of their portfolio or less, with a minimum investment timeframe of 5 years, and with a high to very high risk/return profile.

DISCLAIMER

This information has been provided by BIMAL for WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer.  This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice.  Past performance is not a reliable indicator of future performance.  Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB.  Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.

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