Fund managers like to make a song and dance about the stocks they choose and their prowess when it comes to picking winners but, in reality, many stick close to the sharemarket index, with the odd tweak here and there.

You could save a good deal of money by skipping the hype and buying directly into the sharemarket via an index fund. They charge a fraction of the fees charged by many of the active managers.

These funds replicate or mirror a particular sharemarket index and enable investors to "buy the market'' rather than attempt to pick the companies that will do well.

The smart money the superannuation funds and their asset consultants have long recognised the value of doing precisely this.

Rainmaker Information's research director, Alex Dunnin, says about $88 billion is indexed out of a total managed investment pool of about $730 billion. But consulting actuaries Plan for Life estimate that less than 1 per cent of that is retail money.

In other words, index funds barely register on investors' radar screens. This is easily explained by the lack of commission index funds pay advisers to sell their products the main reason they are low-cost investments. But in the world of managed funds, the gateway to consumers' pockets is through advisers' commissions.

However, if you want exposure to the sharemarket and simplicity these low-cost funds can do the trick.

The way index funds work is simple. Take an Australian share index fund that replicates the S&P/ASX 200 index, which is made up of the 200 largest listed Australian companies by market capitalisation.

If News Corp makes up 6 per cent of the S&P/ASX 200 and AMP makes up 3 per cent, then the index fund will also have 6 per cent of its money invested in News Corp and 3 per cent in AMP. This replication is repeated for the other 198 stocks that make up the index.

So what would you be forfeiting by going down this route? Active managers claim to outperform the market index but they do not always live up to the promise and they are not always problem-free.

Yesterday's star can turn into a fizzer; managers can be victims of their own success, taking on too much money, which can hinder their performance; celebrity managers have been known to get bored, get better offers, or decide to set up shop by themselves.

In reality, consumers are easily mesmerised by a fund manager crowing over its top-performing funds in advertising and are unlikely to know that its other funds have performed poorly or delivered a mediocre result.

For consumers who want to invest in an index fund, the main challenge is to establish where to access the funds.

The Vanguard Index Australian Shares Fund, which tracks the S&P/ASX300 index, has an annual management fee of 0.75 per cent (less for large amounts) or about half the ongoing fees of the typical actively managed Australian shares fund. And it has no entry or exit fees.

However, if you access an index fund through an adviser it can undo the benefit and lift the ongoing fees paid by the investor to about 1.25 per cent a year, significantly reducing the cost-effectiveness of indexing.

On top of this are the ubiquitous master trust fees and these will vary depending on which one the adviser uses.

Dunnin says investors thinking of indexing must be conscious of the fees they pay or they give away one of its main advantages. The best route is to buy the fund directly from the manager.

There are other good reasons to invest via an index fund. Generally, they are more tax-efficient than their actively managed rivals.

Managed fund returns are calculated before taxes. The returns for the investor are reduced by the amount of taxes due on the earnings.

Index funds do not trade shares as much as active managers because they simply track the index.

When active managers do a lot of buying and selling of shares, the amount of realised capital gains is increased. Investors must pay capital gains tax on this distribution, in the year the distribution is made.

As well as lower taxes, the buy-and-hold approach of index funds also means that unitholders face much lower brokerage costs.

But just because index funds make a lot of sense doesn't mean that they are going to put the active managers out of business. In Australia, in shares, the active managers have done much better than managers investing in the US and European stockmarkets.

A study by Vanguard Australia and asset consultant William M. Mercer shows that even after fees are taken out, 48 per cent, or almost half the Australian share funds, were able to outperform the Australian stockmarket over the five years from 1995 to 2000.

Also, in the Australian small companies sector some managers have been able to do very well long term.

The big companies are closely researched, they rarely turn up surprises and their share prices are accurate reflections (with some notable exceptions) of the true worth of the company.

But with the smaller companies, there's simply not enough turnover of shares in them to interest analysts. They want to research the companies that their employers the stockbroking firms can sell to their clients and generate brokerage income.

The lack of research among the corporate minnows leaves plenty of room for fund managers to do their own research and identify undervalued companies to invest in.

The same opportunities for fund managers to beat the index do not exist in asset classes outside of Australian shares. The Vanguard/Mercer study shows that only 10 per cent of listed property securities funds manage to outperform their benchmark over five years.

Likewise, only 10 per cent of international share funds managed to outperform, after fees. When it comes to Australian fixed-interest funds, none was able to beat the index.

A favoured asset allocation strategy by institutional investors, such as superannuation funds, is to use index funds as the core holding of a portfolio.

Often innovations are first taken up by institutional investors on the advice of their asset consultants and then filter down to retail investors.

The idea behind the "core-plus-satellite'' approach is to have a core of broadly diversified index funds, to get the overall costs of the portfolio down, and then to add actively managed funds, or direct shares, to spice up the returns.

The idea is to pay the higher fees for active management only when the manager has a reasonable chance of really outperforming.