Indexing options in your super fund: Pros and cons

After international investment giant Vanguard launched its own super fund in Australia in November 2022, many non-investment types were scratching their heads and wondering why all the fuss and what indexing had to do with their super.

In fact, Vanguard is already a big player in the Australian investment market as one of the largest providers of index exchange traded funds (ETFs), popular with individual investors and SMSFs. Behind the scenes, it has been providing indexed investments to large super funds for many years.

Although some Aussies have already dipped their toe into indexing as an investment strategy when they invest through an ETF, fewer have used the same investment approach with their retirement savings.

Now that Vanguard is offering its indexed investment services directly through a “low-cost, high-quality” super product, it’s timely to learn a bit more about how indexing works and what it means for your retirement savings.

What is an index (or benchmark)?

An index is a collection of investment assets that are grouped together to represent all or part of a broad investment market. It provides an easy way to measure and benchmark the performance of a set of investment assets.

There are indexes for almost every asset class (such as Australian and international shares, property and bonds), as well as for currencies and commodities.

Within each asset class you can also invest in indexes covering a subgroup of assets. In the case of shares, this might be the industry (such as resources and financials), sector (such as the largest global technology or healthcare companies) or geographic region (such as the 20 biggest Asian or European companies).

Investment indexes are designed to reflect the value and market performance – both up and down – of the asset class, sector or industry to which they relate. They are constructed by large international investment companies like Barclays, S&P, Morgan Stanley and Bloomberg.

The performance of well-known local and international indexes (such as the S&P/ASX All Ordinaries, Dow Jones and NASDAQ) is covered daily in the financial media.

Indexing: How does it work?

Indexing is an investment strategy designed to provide exposure to the performance of a specific investment market by tracking the performance of its key index.

To track the index, an investment manager buys assets in the same weighting as they occur in the index they are tracking. The aim is to match or duplicate the return of the index by investing in the whole index or a representative sample of it.

Indexing is sometimes referred to as passive investing as it involves passively buying the market, rather than trying to actively beat the performance of the market by selecting investments you believe will outperform.

What are the pros and cons of indexing?

1. Benefits of indexing

• Better diversification – Investing in all or a representative sample of a market index provides a diversified portfolio and reduces the risk that comes with holding only a small number of assets.
• Reduced volatility – Buying and holding assets over the longer term may reduce volatility and improve your returns.
• Lower cost returns – Picking investment winners is difficult in the long term, so indexing provides a low-cost way to achieve market returns, which tend to increase in the long run.
• Reduced investment costs – By tracking the index, there are less of the normal transaction and brokerage costs associated with regularly buying and selling assets.
• Lower management fees – Tracking the performance of an index means you are not paying for teams of highly paid ‘star’ investment managers.
• Tax efficiency – With indexing, your after-tax position may be better due to a reduced level of trading and lower CGT obligation.

2. Drawbacks of indexing

• No downside performance – Indexes represent the performance of a market, so if that market declines, its benchmark will too. Active managers may be able to limit this by hedging or moving to cash.
• Over-representation of assets – If an asset becomes overvalued, it carries more weight in the index, but the index manager must still hold the asset.
• No control over the holdings – Indexing requires the manager to hold certain assets to replicate the index, so you have no control over which assets your index manager buys.
• Inability to duplicate some strategies – Indexing is limited to well-established investment styles and sectors. Index funds cannot replicate every investment strategy or style used by active managers.
• No potential for higher returns – Index funds cannot outdo the market the way an actively managed fund can, as their job is to replicate – not exceed – the market’s performance. Active management offers the possibility of higher returns.

How do super funds use indexing strategies?

Indexing is based on the theory that trying to consistently pick investments that will achieve higher returns than the market is near impossible. Instead, indexing aims to deliver the same investment return as the benchmark for a particular market – without paying the high cost of actively managing investment assets.

Super funds use indexing to maximise the diversification of their investment portfolios and to reduce their investment risk. Buying and holding investment securities for a long period – rather than regularly trading them – also reduces your fund’s investment costs and helps boost the returns you receive in your super account.

Some super funds blend active and passive investment strategies in a core plus satellite investment approach. This involves investing the core of the fund’s portfolio using index strategies, while the remainder is invested in a series of actively managed satellites the fund hopes will provide members with higher returns.

Which super funds offer indexed investment options?

In addition to using indexed strategies across the fund’s whole portfolio, many large super funds have added indexed options to the menu of investment options they offer to their members.

This means you can choose to invest some or all of your super using an indexed approach – both while you are saving for retirement and also when you decide to invest your super savings in a super pension after leaving the workforce.

The investment fees charged by most super funds on their passively managed indexed options tend to be lower than those charged on investment options using active management. The higher fee levels reflect the fees charged by active fund managers for their skills in selecting individual investment assets – although this doesn’t always result in better performance, as noted above.

Don’t forget that your investment returns within the super system are only taxed at the super capital gains tax (CGT) rate of 15%. This is much lower than the normal CGT rate you would pay on capital gains outside super, which can be as high as 45%.

If you are looking for an easy-to-understand and cost-effective investment option for your super, an indexed investment option may be worth considering.

Consider the 6 points to check before you switch options.

Indexed investment options in super: What’s on offer?

Like their actively managed cousins, the passively managed or indexed invested options offered by super funds come in several forms:

1. Pre-mixed investment options

A pre-mixed indexed investment option is a mix of growth and defensive assets selected with the expectation they will deliver an investment return in line with a pre-set benchmark index over all time periods.

Pre-mixed investment options are usually based on benchmarks such as Balanced, Diversified or High Growth, each of which has a different mix of growth and defensive assets and a different expected investment return.

Some super funds offer their members the chance to select a mix of direct investments. These direct investments usually include the option to invest in index funds managed by large external investment specialists, or in ETFs listed on the Australian Securities Exchange (ASX).

2. Single asset classes

These are an indexed investment option tracking the benchmark index for a specific asset class (such as Australian shares or international bonds). The option is designed to deliver similar investment returns to its benchmark index over all time periods.

Generally, the index-based asset class investment options offered by super funds track the most popular asset classes, including Australian shares, international shares, international fixed interest and property securities (such as real estate investment trusts).

3. Lifecycle funds

A lifecycle fund is an indexed investment option that automatically adjusts its investment mix (or asset allocation) according to the investor’s age. These investment options hold a higher level of growth assets when you are younger and gradually add more defensive assets as you age. The underlying investment assets are passively managed in the same way as pre-mixed and single asset class options.

Who’s offering indexed investment options?

Many of the major industry and retail super funds offer both their accumulation and pension members indexed investment options.

Industry fund heavyweights like AustralianSuper and Cbus offer Indexed Diversified options, while HESTA offers an Indexed Balanced Growth option, and Hostplus offers both an Indexed Balanced option and several indexed options covering single asset classes.

Australian Retirement Trust (ART) provides a Balanced Index option to its members. ART also offers a range of passively managed single asset class options (such as Australian Shares, Emerging Markets Shares, Diversified Bonds and Australian Property). 

Large retail super funds such as AMP’s MyNorth, CFS FirstChoice Employer Super and Mercer Super Trust also offer fund members a wide range of indexed investment options covering both pre-mixed and single asset class portfolios.

Increasingly, many super funds (such as Netwealth Super Accelerator Plus, Care Super and NGS Super) are offering their members Direct Investment options. These allow you to select and invest directly in ETFs, which are another way to access indexed strategies.

Several smaller entrants to the super market (such as Virgin Money Super, Spaceship, Superhero Super and Kogan Super) offer fund members the opportunity to invest their super using low-cost indexed strategies. These new super funds say they offer members the opportunity to invest their super account “the way you want”. For example, Future Super offers a Balanced Index option that includes no fossil fuels, allowing members to take advantage of the benefits of indexing while embracing a socially responsible investment approach.

It’s worth noting, however, the investment options offered by these newer super funds usually invest through ETFs or the large indexed managed funds offered by the international specialist index fund managers, such as Vanguard, BlackRock and BetaShares.