Do I need to do that?

If you're cheesed off with paying hefty fees to fund managers for the privilege of losing money, it might be time to take a look at index funds. Instead of trying - and often failing - to beat market returns, as active fund managers do, index funds offer market performance. Nothing more, nothing less.

The attraction is that by replicating the index, these funds can deliver market returns at much lower costs than actively managed funds. They don't need to employ high-flying fund managers or teams of analysts; because they tend to buy and hold stocks, they can deliver better after-tax returns than funds that rely heavily on trading.

Many institutional investors use index funds as their core holding in an asset class (such as Australian shares) and add specialist funds (such as small company funds or funds with particular strategies) to enhance the market return.

Index funds have been slower to take off with retail investors, at least partly because many index managers don't pay commissions to financial planners. However, Robin Bowerman, Vanguard's head of retail, says they are growing in popularity as planners have learned how to use them in portfolios and been able to access them through platforms.

How do they work?

Morningstar's editorial and communications manager, Phillip Gray, says the simplest form of indexing is for the fund manager to buy the stocks in a particular index (such as the ASX 200) in the same proportions as they are represented in the index. So, if BHP makes up 11 per cent of the index, 11 per cent of the fund will be held in BHP shares, irrespective of whether or not the fund manager reckons they're a good deal. This approach is called full replication.

The other approach is known as sampling or optimisation. Bowerman says holding all the securities in an index can get expensive and messy. "Optimisation is about common-sense execution," he says.

For example, Vanguard offers an index fund using the ASX 300 index but typically holds 240 to 250 of the top 300 stocks. "As you go down in size, the smaller companies add very little in the way of performance to the index and can become expensive to trade," he says. "They can drop in and out of the index, so you're forced to buy and sell them. Some can be quite illiquid, which makes it hard to get in and out."

He says the index return doesn't reflect such things as transaction costs. By getting the execution right, he says, Vanguard aims to provide an index return after these costs. By limiting trading, the after-tax return should be better.

But won't I do better in a good actively managed fund? Probably. However, Bowerman and Gray say it is difficult for an active fund to consistently beat the market, particularly after fees. It is telling that Vanguard (and other index funds) typically deliver slightly above-average performance.

Bowerman says index funds can also reduce risks by providing greater diversification. "With most investments you have market risk, security risk and fund manager risk," he says. "With index funds, you take out the first two."

How much cheaper are they? It depends on which asset class you're looking at (index funds are available for all main asset classes, not just shares) and how you get access to the fund (if you go through a platform, you'll incur additional fees) but it should be substantially cheaper. For example, the average actively managed Australian share fund has fees of about 1.8 per cent but index funds are available with fees as low as 0.14 per cent - though you'll need a sizeable investment to get that rate. Bowerman says Vanguard charges 0.75 per cent on its Australian share fund for accounts of less than $50,000, reducing to 0.34 per cent on more than $100,000.

What should I look for in an index fund? Gray says you should know how much you're paying and what the payments are for - as fees can make a difference to performance. You also need to know what index is being used (a broad portfolio such as the ASX 300 will perform differently than a more concentrated portfolio such as the ASX 100) and what sort of tracking error is likely. Bowerman says a tracking error (the amount by which the portfolio can diverge from the index return) of about 0.2 to 0.3 percentage points is probably acceptable.