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Is passive index investing the best way to go?

There has been an enormous shift in recent years towards passive index investing, particularly towards exchange-traded funds (ETFs).

An index is simply a list of shares that has been selected, usually due to their market capitalisation sizes. For example, the ASX 200 and ASX 300 are indices based on the 200 and 300 of the biggest businesses listed in Australia. One of the most well-known Australian index funds is Vanguard Australian Share ETF (ASX: VAS).

Index investing is very simple. You just pick the index you want to invest in and steadily add money to it. It takes very little research and minimal effort to administer. An easy life! Just be patient.

The great thing about index investing is that some of the players offer funds at extremely low costs thanks to Vanguard disrupting and revolutionising the cost structure. Now iShares S&P 500 ETF (ASX: IVV) is on offer for a tiny annual management fee of 0.04% in Australia, as are a few other options.

Many studies in the US have shown that over longer periods of time, many US fund managers underperform their benchmark after fees. Fees are a key detractor from net returns. If two funds generate a similar return then you want the lowest fees.

In Australia the percentage of fund managers outperforming is higher, but still not great.

For a lot of people the best thing to do is to choose a simple, diverse index fund like Vanguard MSCI Index International Shares ETF (ASX: VGS) and spend your time doing other things.

However, for me those studies actually say a few things. First, you shouldn’t just invest in any fund manager – they should be worth the cost. Second, it’s a comparison of active management versus passive, it doesn’t mention choosing your own portfolio.

Index returns will create, at best, average returns – of course. Many people do underperform that due to fees, impatience and poor investment choices.

However, I fully believe that a long-term focused portfolio which only holds quality businesses with market-beating attributes purchased at good value will easily beat the market over a five plus year time period.

Foolish takeaway

Whilst most people on the street would heavily benefit by investing in shares with a diversified index like the S&P 500, I think it’s possible to beat those indexes with quality shares like Challenger Ltd (ASX: CGF) and Costa Group Holdings Ltd (ASX: CGC), particularly when you add in the benefit of franking credits.

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Motley Fool contributor Tristan Harrison owns shares of Challenger Limited and COSTA GRP FPO. The Motley Fool Australia owns shares of and has recommended Challenger Limited and COSTA GRP FPO. The Motley Fool Australia has recommended Vanguard MSCI Index International Shares ETF. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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