Index funds were once regarded as the domain of mum and dad investors with neither the know-how nor the money to access the sophisticated managed investments offered to wealthy clients. Not any more.

During the global financial crisis, active fund managers with strategic stock selection and sophisticated trading strategies were no better at outwitting the market than the rest of us.

Once fees were stripped out, many delivered lower returns than a passive investment in an index fund.

Not surprisingly, super funds, personal investors and their advisers have voted with their feet and shifted money into low-cost index funds.

"In bull markets, where people are earning returns of 30 per cent a year, people are not cost-conscious," says Tony Rumble of Alpha Structured Investments. "Now we're back into a market where the focus is on costs."

Nigel Baker, of WHK Horvath Wealth Management, says a decision to use a passive index approach helped clients weather the crisis: "We're looking for the best return for clients on an after-costs after-tax basis and active funds don't consistently provide the best outcome," he says.

Doug Turek, of Professional Wealth, also uses index funds in his wealthy clients' portfolios, although he stresses that while index funds are great building blocks, they are not the whole story.

"If someone comes to me and asks where to start, I say they should have an ETF [exchange traded fund] for exposure to the broad market. Maybe half [your money] in index funds is not a bad compromise," he says.

While the financial crisis highlighted the issue of value for money, the shift to index funds is due in part to the local market reaching critical mass. Traditional index funds have had a solid following since the late 1990s but it is the more recent growth in ETFs that has driven growth. After a quiet introduction in 2001, there are 25 ETFs with a combined market value of $2.93 billion, up by 141 per cent in the past 12 months alone. Vanguard Investments launched its first ETFs in May and passed $100 million in funds under management in just 10 months.

Because there is no stock-picking involved and very little turnover of the underlying shares or securities, index funds are cheaper than actively managed funds where you pay professionals to pick stocks that will hopefully outperform the market.

There's the rub. According to figures from Morningstar, barely half of actively managed Australian share funds outperformed the index last year (see table). That rises to 60 per cent over 15 years, partly due to survival of the fittest. A handful of fund managers have a good track record but it's rare to find a fund consistently ahead of the herd.

"The best index investor is someone who has tried active funds and understands how hard it is to pick managers before they outperform [the market]. The big problem is that people pick last year's best managers," says the head of retail at Vanguard, Robin Bowerman. "If you have high confidence in a manager to outperform, by all means invest, but what is disappointing is where people pay high active fees and get below-market performance."

Role of costs

The difference in fees between index funds and their retail equivalent can be significant (see table). For example, Vanguard's Australian Shares ETF charges a fee of 0.27 per cent a year while its Index Australian Shares Fund charges 0.75 per cent.

This compares with 1.87 per cent for the average retail managed fund equivalent and just below 1 per cent for a wholesale fund available via wraps and master trusts.

While this may sound like splitting hairs, small differences can add up, as many large institutional investors discovered. Most big super funds now use indexing for some of their investments, saving members millions of dollars. Last year AustralianSuper slashed the number of Australian equity fund managers it invests in from 32 to eight and increased the passively managed money from one-quarter to half of the total. Australia's largest super fund had discovered that active managers were not outperforming to an extent that could justify the fees.

The move cut fees by $9.3 million to about $700,000 without sacrificing performance.

Individuals can use the same strategy, albeit on a more modest scale. However, investors should also factor in the cost of brokerage with an ETF, which is a minimum of about $20 each time you buy and sell units. If you want to purchase additional units on a regular basis, you may be better off buying a traditional index fund with slightly higher fees but no brokerage.

Turek says index funds are useful for wealthy investors who can't put all their money in super but don't want the tax liability generated by active funds.

These may turn over 100 per cent of their portfolio in a year, so their distributions consist of capital gains taxed at the investor's marginal rate.

Baker says that even when the return from an active fund looks good it may have a worse after-tax outcome than an index fund, which buys and sells only when necessary to reflect changes in the underlying index.

Core and satellite

While bear markets have a way of getting rid of bad investments and lazy investing habits, even the most ardent supporters of index funds agree that both index and active approaches have a role. The trend these days is the core-plus-satellite approach to investing, which splits a portfolio into two segments.

Rumble explains that a core portfolio is based around index funds that provide market returns at low risk for low fees. Satellite investments are added to provide above-market returns. These are actively managed and might be anything from commodities to inflation-linked bonds or unlisted property.

Although the increased focus on index funds is a direct result of the financial crisis, Bowerman says the debate should move beyond index-v-active funds.

"What the GFC taught advisers and self-directed investors in the most powerful and painful way possible was that asset allocation is the most important factor for investors. In 2008 what determined whether you had a good or bad year was the percentage you had in each asset class," he says.

This is borne out by Russell Investments in a study of the average annual return of all major asset classes over the past 30 years. It turns out that a balanced portfolio with 70 per cent growth assets such as shares and property and 30 per cent bonds and fixed interest provided a better return than any single asset class except shares.

A balanced portfolio returned 12.6 per cent a year compared with 14.9 per cent for Australian shares but with about half the risk. In other words, a long-term investor could earn 12.6 per cent a year and sleep easy simply by diversifying across asset classes.

The easiest, most cost-effective way to do that is to have a core index portfolio. Advocates of the core-plus-satellite approach argue that once you've created a cost-efficient and well-diversified core portfolio, you can start to have a bit of fun with the rest of your investments.

"If you have half of your portfolio in index funds you can entertain your convictions or hobby ideas," Turek says. "For example, you might invest in green energy or gold."

Index funds are also an effective way to benchmark your investment returns, something few people do well. You may think a return of 10 per cent on your share portfolio is adequate until someone points out that the market was up 20 per cent over the same period.

"Two out of three times when we examine clients' direct-share portfolios they would have underperformed the market and been better off in an ETF," Turek says. "If you owned 10 stocks during the financial crisis and only one of them was an Allco or ABC Learning it would almost guarantee you underperformed the index. An index fund is a safer investment and removes concentration risk."

But he points out that index funds are not risk-free. For example, the ASX 200 index, which is often used as a proxy for the entire Australian sharemarket, has 60 per cent of its investments in just two sectors, banking and resources. That has served investors well in the past decade but there is no guarantee those sectors will continue to outperform.

Index comes up trumps

David Robb admits being "almost Jesuitical" in his belief in index investing. "I proceed from the premise that it's difficult for an active [fund] manager to outperform the index," the semi-retired financial adviser and chartered accountant says.

"I frankly don't know how to pick active managers that are going to outperform [the overall market return] and I don't know anyone who does," Robb says. "There is no consistency to it."

Robb discovered index funds when he was studying at the Chicago business school in the mid-1980s and was frustrated he couldn't invest in similar funds in Australia. When Vanguard opened an Australian offshoot in 1997, he ditched all his managed funds in favour of the index offerings from that company.

Shortly afterwards, Robb added Dimensional Fund Advisors, which has a broad market approach, and, more recently, ASX-listed exchange traded funds. "Both Vanguard and Dimensional manage funds for an after-tax return, which is very important," Robb says.

He also moved his clients into index funds, which meant an end to lucrative trail commissions from more expensive active funds.

"I walked away from trail commissions with delight," Robb says. "A good general rule is not to invest with funds that pay any commissions."

Like many experienced investors, Robb has watched Australian fund managers that have outperformed the market for years but then fallen victim to their own success.

As investors pour money into these funds, it is more difficult to act quickly and nimbly in the relatively small Australian market.

"It is like the difference between turning a row boat in Sydney Harbour versus turning a battleship."

Robb uses index funds as much as he can in his own and his remaining client portfolios, plus an active manager, Kerr Neilson's Platinum Asset Management, which invests in global markets.

"He's playing in a huge ocean, not Sydney Harbour; when he buys, he doesn't move markets," Robb says.

How it works

Index funds are pooled investments that passively track the performance of a particular market index. For example, if you invest in an index fund that tracks the ASX 200 index and the market rises or falls by 10 per cent, so will your fund.

There are several types of index funds. Some hold all underlying securities in a given index while others select a representative sample. And whereas traditional index funds have a limited number of units and must be bought and sold via financial planners or fund managers, exchange traded funds can issue new units that can be bought and sold on the market just like shares.

Four Australian equity ETFs are currently offered by Vanguard and State Street and 21 overseas funds are offered by BlackRock's iShares and Vanguard.

There are also five exchange traded commodities funds that invest in gold, silver, platinum, palladium or a basket of the four.

While locally available ETFs are currently limited to shares, listed property and commodities, traditional index funds also offer exposure to bonds and fixed interest.