Source: Wealth Creator Magazine January/February 2006

Diversification is a simple and effective way of reducing risk within a portfolio.

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Growth Plan: Index Funds And Put Diversification To Work

Source: Wealth Creator Magazine January/February 2006

Growth plan: index funds and put diversification to work.

Image this scenario. You find yourself with a spare $10,000 to invest, and you are weighing up your options. Around the water-cooler one day, your colleagues are raving about Acme Computing and the performance of its shares. Your decision is made – you invest your entire savings in the global technology company.

What are the chances of this story having a happy ending? Unless Acme Computing is giving Microsoft and its stable mates a run for their money, chances are you have entered a high-risk investment situation. And even Microsoft isn’t indestructible.

The best way to reduce risk

Putting all your eggs in one basket is a risky business. Keep this in mind, and you are on track to a successful investing experience. Known as diversification, it is a simple and effective way of reducing risk within a portfolio rather than improving the expected return.

Diversification involves investing funds in numerous assets and classes with differing risk profiles, thus minimising the overall risk of your portfolio. Not only should the individual risk profiles differ, but they should have an inverse relationship. The result? Your investment’s performance is on a steadier keel, as the losses from some investments are offset by potential gains in others.

Optimal diversification can be achieved in a number of ways:

  1. Allocating funds to various asset classes (cash, fixed interest, property and shares). By diversifying across asset classes, any losses in one particular asset class are usually offset by gains in others. You may choose to further diversify your portfolio within a specific asset class, for example investing in domestic and international shares.
  2. Varying the risk in your shares. Most portfolio theorists agree that a selection of 20 shares in your portfolio reduces most of the individual share risk (based on the assumption that shares are selected from various industries and a range of company sizes).
  3. Varying your shares by industry, to minimise the impact of industry-specific risks.
  4. Diversifying across investment managers. By allocating funds to various investment managers who are independent of each other, your investment is exposed to a range of management styles that may complement each other. In doing so, your portfolio should generate healthy capital growth over the long-term at a reduced level of risk and volatility.

The new way forward

Selecting a range of share options for your investment is a great diversification strategy if you have solid business knowledge and a good understanding of the market. Not so great if, like many investors, you feel that there is a wealth of knowledge out there beyond your reach. If you can’t beat the market, why not join it? This is the premise behind index funds – which mimic the performance of selected indexes. The index might be the S&P/ASX 300, the MSCI World Index, or one of many others out there. Still relatively new to the Australian market, are index funds the best kept investing secret?

They certainly have a number of hidden benefits. Firstly, they are a cheaper way of investing – because an index fund is not an actively traded portfolio, the level of turnover is reduced and so entry fees and exit fees are kept to a minimum. This also reduces the amount of capital gains tax you have to pay.

Secondly, indexing has the ability to offer broad diversification. By adopting an indexing approach, investors limit their exposure to the volatility of an individual share. Subsequently, the investor will moderate the volatility of their portfolio and ideally generate consistent investment returns over a specific investment time horizon. It must be noted that, in a smaller market like our own, only a select few shares dominate the market and the ability of index funds to provide a truly diversified portfolio is limited to some degree.So how do they work? Your index fund manager will create an investment portfolio that matches the selected index, by purchasing shares using the percentages indicated by the index. Instead of actively buying and selling shares, the portfolio ‘sits tight’ and the fund manager adopts a ‘buy and hold’ approach. So instead of sweating it out trying to pick winners (and inevitably suffering through the times when a loser is backed instead), the investment rides with the index.

There are two approaches to indexing that your fund manager will choose from:

  1. Full replication: The manager will buy every share in the selected index in proportion to their weights in the index, which can be a costly exercise because of the high number of transactions involved.
  2. Optimisation: The index manager will only purchase a sample of the securities in the selected index. Despite reducing transaction costs, there is a real risk that the portfolio manager will not be able to match the index return.

With index funds, investors can sit back and watch their investment grow over the long term. There is no active leg-work required – instead, the investment is carried along by the momentum of the selected index and should generate healthy returns for your capital.

Diversity works

Smart investors are diversifying their portfolio to take advantage of ever changing market conditions and to protect against downturns. So next time you have a spare $10,000 lying around, instead of hanging around the water-cooler, seek out an index fund manager and find out what they have to offer.

references

  1. Clevland, D., 2005, Sit back and enjoy the passive approach, The Sydney Morning Herald, 15 March, www.smh.com.au.
  2. Collett, J., 2005, Story with an index, The Sydney Morning Herald, September 6, www.smh.com.au.
  3. Dimensional Australia Limited, 2005, viewed on the 30/09/2005, www.dimensional.com.au.
  4. Investopedia, 2005, viewed on the 30/09/2005, www.investopedia.com.
  5. MacDonald, A., 2005, A world of diversification, Independent Financial Adviser, March 28 – April 3, www.ifa.com.au.
  6. Path to Investing, 2005, viewed on the 30/09/2005, www.pathtoinvesting.org.

 

Written by:

James Thier is an Executive Director of Australian Ethical Investment Ltd and a Director of its wholly owned subsidiary, Australian Ethical Superannuation Pty Ltd – a public offer fund. A founding board member of the Ethical Investment Association and is also a director of the Centre for Australian Ethical Research .