This article has been written by expert contributor, Tony Kaye, Senior Personal Finance Writer, Vanguard Australia.
A key benefit to investing in broad index funds is the in-built sector diversification that they provide.
Vanguard’s founder, John C. Bogle, famously said: “Don’t look for the needle in the haystack. Just buy the haystack!”
What he was saying is that, rather trying to find one listed company or a few companies that may deliver a great investment return over time, it’s safer to invest much more broadly across the wider universe of listed companies.
It was this belief that led to Vanguard launching the very first index managed fund in 1976.
The First Index Investment Trust, trading as the Vanguard 500 Index Fund, had a share portfolio constructed to match the top 500 companies that were listed on the United States share market at that time.
Tracking all of the company constituents of the well-known S&P 500 Index, it was essentially the first ever share market haystack.
That’s because, through a single investment fund (the haystack), investors were able to gain exposure to 500 major U.S. companies at once.
Now, almost 50 years later, what some fund managers once described as “Bogle’s folly” has evolved into a US$16 trillion global industry.
Investing in low-cost managed funds and exchange traded funds (ETFs) that provide instant exposure to hundreds, and sometimes thousands, of companies at once has become the norm for millions of investors worldwide.
The benefit of buying haystacks
The world has changed a lot over 46 years, and that’s reflected by the companies that now rank as the biggest by their share market value compared with those holding the top places when Vanguard’s first index fund was launched in the mid-1970s.
Top listed companies by market value
| Rank | 2022 | 1976 |
| 1 | Apple | Exxon |
| 2 | Saudi Aramco | General Motors |
| 3 | Microsoft | Texaco |
| 4 | Alphabet (Google) | Ford Motor |
| 5 | Amazon | Mobil |
| 6 | Tesla | Chevron |
| 7 | Berkshire Hathaway | IBM |
| 8 | Meta Platforms (Facebook) | Gulf Oil |
| 9 | Taiwan Semiconductor | General Electric |
| 10 | UnitedtHealth Group | Chrysler |
Sources: Statista and CNN Money. Rankings as at 22 August 2022.
What’s clear from the table above is that technology companies now dominate the global share market rankings.
In the mid-1970s the rankings were dominated for the most part by big oil companies and automotive manufacturers.
The make-up of the biggest companies on the Australian share market has also changed markedly since the 1970s.
As well as financial institutions now accounting for five of the 10 largest companies, the top company rankings include former Commonwealth-owned entitles that have been privatised and several businesses that weren’t in existence in the 1970s.
The point is, the biggest companies on a share market will invariably change over time, for a whole range of reasons.
That could be because of mergers, takeovers, companies privatising or going out of business, or simply because of industrial evolution (as shown in the table).
Yet, if you’re invested in a broad index fund, you’ll always be invested in all of the companies that are contained within the share market index that it tracks.
In effect, who those companies are isn’t really that material. It’s more about always having exposure to the top – and often the best-performing – listed companies.
Using Australia as another example, the S&P/ASX 300 Index tracks the top 300 companies listed on the Australian Securities Exchange (ASX).
Both the Vanguard Australian Shares Index Fund (managed fund) and the Vanguard Australian Shares Index ETF (trading as VAS) invest in all of the companies within S&P/ASX 300 Index.
So, through a single investment, it’s easy to invest in Australia’s 300 biggest companies.
Broad diversification
There’s another key benefit to investing in broad index funds, of course, and that’s all about the in-built sector diversification that they provide.
If you invest in a single company, you’re basically only buying into that company’s operations and the particular sector in which it operates.
Investing in a few companies can provide you with some diversification, unless all of those companies are operating in the same market sector.
According to the ASX, the Australian share market is broken up into 11 key sectors, 24 different industry groups, 68 industries, and 157 sub-industries.
From an investing point of view, you’d need to invest in 11 separate companies to have an exposure to each of the key share market sectors.
To cover off all the large industry groups, you’d then need to invest in 24 separate companies on the ASX.
You’d need to pay brokerage fees on each company investment, which can really add up.
But, even then, you’d still only have exposure to a handful of companies and some industries.
Alternatively, one investment in a broad managed index fund will provide exposure to many companies operating in many different sectors.
Think of it as the metaphorical market haystack.
And, if it fits in with your investment strategy, you can repeat the process for other international markets to build a highly diversified global shares investment portfolio.
Tony Kaye is Senior Personal Finance Writer at Vanguard Australia. In his role, Tony regularly produces topical investment-related articles and educational content designed to help investors make well-informed decisions. Tony is a former managing editor and financial journalist, and his articles are published in Vanguard’s weekly Smart Investing newsletter and elsewhere. The above material has been republished with the permission of Vanguard Investments Australia Ltd.
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Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.