Which Index Fund – if Any?

Index funds invest in all the shares in a sharemarket index. For example, the TENZ fund invests in the ten biggest companies that make up the NZX 10 index.

In New Zealand, index funds have a big advantage over other share funds, which are called active funds because their managers decide which shares to buy and sell. Unlike active funds, index funds' capital gains are not taxed.

This difference, however, is scheduled to disappear next April if controversial proposed tax changes become law. All funds holding New Zealand and Australian shares won’t be taxed on their capital gains, and all funds holding shares in other countries will be taxed – regardless of their index or active status.

Even if the changes come into effect, though, I still think index funds are better. That's because nobody has to do research on which shares to hold, and index funds trade only infrequently, when the index changes. Lower costs mean lower fees, which can make a big difference over the long term.

Let's say you invested $10,000 for 20 years, with an average return before fees of 9 per cent a year. In an active fund, with 1.5 per cent fees, your investment would grow to $42,500. In an index fund with 0.75 per cent fees, it would grow to $48,800.

Active fund managers often say they make up for the difference by getting higher returns. And some do. But over the years, most do worse than index funds after fees. And there's no way of knowing in advance which few will do better. Index funds are a better bet.

Now for the reader's question: "As part of my investment strategy I want to invest $15,000 in a cross section of NZ shares," she writes. "What are the advantages of investing all in FONZ rather than some in each of TENZ and MIDZ? (I would imagine management fees would be less to invest in just one fund?)"

We've already met TENZ. FONZ invests in the NZX 50 index of the biggest 50 shares, and MIDZ invests in NZX MidCap index of the 11th to 50th shares excluding offshore-based companies. Currently the exclusions are eight Australian companies plus GPG and BIL International.

All three funds are run by a subsidiary of the stock exchange and are listed as exchange traded funds, so you can buy them like shares.

To keep things simple, we'll compare investing $15,000 in FONZ with $7,500 in each of TENZ and MIDZ. The main differences are:

· FONZ's index is set up so that no share can make up more than 7 per cent of the fund. However, TENZ and MIDZ are weighted according to the total value of each companies' shares. Telecom therefore makes up 29 per cent of TENZ, Contact Energy makes up 15 per cent, and Fletcher Building, 14 per cent. The domination of those companies adds to total risk.

· TENZ and MIDZ together hold 40 shares, while FONZ holds 50. And given that those extra ten are offshore companies, their inclusion in FONZ adds considerably to its diversification.

· The TENZ fees are lower than on the other two, so the reader's assumption about fees is wrong. In a typical year – the fees vary with performance – they might total $90 to $95 on TENZ plus MIDZ and $110 to $115 on FONZ.

However, the fee difference is not big enough to outweigh the superior diversification and more equal weighting in FONZ. It's the clear winner.