PORTFOLIO POINT: The cheaper fees charged by index funds mean they are still attractive in a falling market.

Index funds have long appealed to conservative investors, who like the promise of steady long-run returns and automatic diversification. But with the recent turmoil in global markets, has their appeal increased to a broader spectrum of the market?

On the face of it, the evidence from the immediate aftermath of the crisis would suggest not. Alex Dunnin of Rainmaker says overall Australian funds under management shrank 14% between June and December last year, while indexed assets shrank 13% - a negligible difference. But speak to Robin Bowerman, head of Vanguard Australia's retail operations, and a very positive picture emerges. "We've seen a shift towards index funds and passive investing generally; strong positive cash flows from the retail adviser business and also the retail business market," he says.

Compared with an "actively" managed fund (in which a funds manager constantly shuffles the portfolio in an attempt to beat the market), index funds are essentially stable and reflect the weightings of individual companies in a given index. Some funds track the index exactly in terms of companies represented and respective weightings, while others, such as Vanguard's Australian Shares Fund, use a "large representative sample" of the index. Such an approach may be used when small players drop in and out of an index frequently; transaction costs make it inefficient to track an index precisely.

By definition, an index fund cannot hope to outperform the market average - its task is to follow it as closely as possible. Perversely, this improves investors' chances of getting a better return than with an active managed fund. Ostensibly, the big advantage of an index fund has been low fees, but several academic studies have found that the majority of fund managers have great difficulty simply matching the index average.

Yet it has taken a crisis to prompt a pronounced shift from active to passive investing. Bowerman offers this explanation: "We've gone through a severe market environment - people are focusing on what value active managers add. Their appeal was the promise they would get out when they're [the market is] going down - which most of them didn't."

One reason for this is a phenomenon known as "index hugging", the idea that fund managers, especially those working for larger funds, tend to have portfolios that largely reflect the makeup of an index fund. Dunnin says an estimate of 70-80% of managed fund returns being the result of index hugging "sounds about right".

nAustralian share index funds performance to December 31, 2008
	Min invest	Min additional investment	Entry fee	Ongoing annual fee	Exit fee	One year	Three years (pa)
Vanguard Australian Share Index Fund	$5,000	100/1000 (A)	0%	0.75% (B)	0.10%	-38.79%	-4.16%
ANZ Online Investment Account *	1000	100	0.25%	1%	0.25%	n/a	n/a
S&P / ASX 300 Accumulation Index	n/a	n/a	n/a	n/a	n/a	-38.92%	-4.03%
A: Bpay $100, cheque $1000. B: For less than $50,000; fees reduce for larger amounts. * ANZ launched this fund in November 2008, so performance figures are not yet available. Source: Choice

It's also worth considering the effect of actively managed funds on your tax bill. Even if a fund manager does beat the index, the capital gains tax bill can eat into their returns. And fund managers who are successful at beating the market over a short period often tend to have difficulty keeping up their record.

Likewise, the current investment climate should be considered a factor. Bowerman says it is presently more about markets than managers. "In a 15-20% growth market, the fee differential [compared with an actively-managed fund] isn't so apparent. But [as] one of my clients said to me recently, ‘I don't need to pay fees to lose my money, I can do it myself'."

For many people, the term "index fund" is synonymous with Vanguard, which is credited with creating the world's first index fund in 1976. In Australia the firm holds a third of the total market for index assets, having caught up to and recently passed State Street (30%). But narrow the scope to retail only, and Vanguard is the dominant player.

In large part, this is due to its relatively comfortable status locally as one of just two players that offer stand-alone investments in index funds for retail investors (BankWest also offers a fund linked to the ASX 200; all others are only available through wrap accounts or master trusts). Of the two, Vanguard offers the lowest fees, although its annual management fee of 0.75% is five times that of the firm's equivalent fund (Vanguard 500) in the US.

Why the discrepancy with the US? Vanguard Australia says the main reason comes down to the scale of the respective markets ($US1 trillion as opposed to about $A60 billion), plus the maturity of each fund; the Australian operation was only set up in 1996. Another factor, perhaps, may be a lack of competition in the local marketplace - although this may be changing soon. SuperRatings chief executive Jason Clarke expects "the introduction of low-volatility investment funds as a general trend", although he adds it would be difficult for them to make a meaningful dent in the market, given the sheer scale of Vanguard and State Street.

An alternative is to invest in an exchange-traded fund, or ETF. These operate on a "similar but different principle to index funds: the underlying asset you're buying into is still a weighted bundle of equities, but in terms of structure, they effectively operate as shares, being traded on the open market, and so are considerably more volatile. In general, returns will be fairly similar to an index fund, because you're buying into the same core investment: a bet on the fortunes of a given index. The fees are attractively low, too, at 0.2-0.3%.

However, if you trade frequently, these gains will be wiped out by brokerage fees, which can represent a significant sting, especially on small sums. ETFs work best when the sum being invested is relatively large, and trades are infrequent.

Of course, the notion of investing in an index through a linked fund or an ETF raises an obvious problem, that your investment's fortunes are in part dependent on the performance of some equities you probably wouldn't normally touch (say, a Babcock & Brown). This is the flipside of an approach that some characterise as fundamentally lazy, or at least lacking in intellectual rigour.

But Scott Francis, of A Clear Direction Financial Planning, disputes this notion. He argues that index funds harness the relative pricing efficiency of the market, so at least in theory, future prospects are already "built-in" to your buy-in price. "You can think of each [share] price as a very sophisticated research instrument that takes into account, and reflects, all the information known about that stock," he says. "And the reality is that no individual company is that big in the overall index, so [a poor company] doesn't have that big an effect on your overall investment."

It's also worth noting that every Australian has a stake in the fate of index funds, because almost all of the Government's Future Fund shareholdings are invested via Vanguard and State Street. Many super funds also make use of indexing. It's an approach that makes sense for a long-term investor looking to maximise the benefits of a buy-and-hold strategy.

It's also a point reflective of index funds generally. If you're happy to take risks and are confident in your ability to outperform the market, index funds probably don't have a lot to offer. But as a way to diversify while offering solid long-term returns, index funds are a compelling alternative for risk-averse investors, and a surprisingly competitive one against many managed funds.