Because these funds do not employ the services of a fund manager they provide investors with a low cost option of investing in a particular market or sub sector of a market.

Numerous research studies, both within Australia and overseas, have suggested that many actively managed investment funds have failed to outperform their respective index over time. So if this is the case, why not just invest in index funds?

While all this looks fairly attractive on the surface, one of the major shortcomings of index funds is that they purchase investments based on market capitalisation. Therefore, as a company’s share price increases and that company makes up a larger proportion of the index, the index fund is forced to buy more of that company’s shares. On the flip side as a company’s share price is reducing the index fund is forced to sell shares in that company.
It is fairly clear to see that index funds tend to operate in contrast to one of the basic investment principles, being to buy low and sell high.

In our view a far more effective way to invest is to take a valuation based approach in which shares in a company are purchased with reference to their fair valuation and not market capitalisation. Investors are wise to buy companies that are trading at a discount to their fair valuation and hold on to them long enough to offset short term volatility.