Index fund investing: a complete beginner’s guide

George Sweeney 13th Apr 2022 No Comments

Reading Time: 7 minutes

You might hear plenty of investing experts bang on about index funds and what a great investment they can be. But they tend to overlook the basics and don’t explain what an index fund is.

So, to help you on your investing journey, this epic guide covers everything you need to know about this type of investment. You’ll learn all about what these funds invest in, how they work, and – whether you can make money by using them.

Keep reading for all the essential details or click a link below to jump straight to a specific section…

• What is an index?
• What is an index fund?
• How an index fund investment looks
• Benefits of index funds
• Disadvantages
• Difference between an index fund and an ETF
• Are index funds a good investment?
• The best index fund
• Popular funds
• How to invest
• Alternatives

 

What is an index?

Don’t be put off by the fancy-sounding name, it’s basically a list. The word ‘index’ refers to categorising something into a group. In this case – investments.

An index allows us to measure a group of investments in a simple and straightforward way.

Some common examples of indexes you may have come across (or heard journalists screaming about on the news) include:

• FTSE 100
• FTSE 250
• S&P 500
• Dow Jones
• Nasdaq

These indices are just long lists containing some of the biggest and best companies in the UK and the US.

But, an index can track all sorts of things. There are actually over three million stock market indices across the globe!

Each one tracks the performance of a group of assets. This is why investment funds that follow or copy an index are sometimes called ‘tracker funds’.

 

What is an index fund and how does it work?

This is a single investment that tracks the performance of all the assets within that particular index.

When the index average goes up – or down – your share value does the same. This varies every day as the markets change.

So, if you wanted to invest in the top 100 companies in the UK, the easiest way is to invest in a FTSE 100 index fund.

This is because, instead of making individual investments into each of the one hundred companies – you can own a piece of each business with a single investment, using an index fund that tracks the FTSE 100.

 

What an index fund investment looks like

Index funds are also usually ‘market-cap weighted’. This sounds super fancy. But, all it means is that the biggest companies in the index fund receive a larger portion of your investment.

So, in practice, if you were to invest £100 into a FTSE 100 index fund:

• Roughly 40% (£40) would go to the 10 largest companies
• Around 60% (£60) would be split amongst the remaining 90 companies

Investing into an index fund does limit your choice and investment control.

Because you’re investing into the whole index, you don’t get to pick and choose which shares you want to invest in.

This market-cap weighting can make these investments a little ‘top-heavy’. But, your money is often safer invested with the larger firms because smaller companies can be riskier.

 

What are the benefits of an index fund?

Here’s a breakdown of some of the unique advantages you’ll get when investing this way:

• Simplicity – one single investment means you can own shares in lots of different companies.
• Cost – because most index funds are not managed, they’re usually very cheap to invest in.
• Diversification – investing this way will diversify your portfolio, putting your money into a range of different stocks or assets. This can reduce your risk.
• Easy to manage – the companies in an index update automatically, so there’s minimal work for you. The passive nature saves you time and effort, meaning you can sit back and let it do its thing.

 

What about the disadvantages?

No way of investing is bulletproof, and there are always downsides to consider. Here’s a few of the potential pitfalls of investing this way:

• Lack of control – you don’t get to choose what’s in an index. You could indirectly be funding companies that you really don’t want anything to do with.
• Top-heavy – the market-cap weighting means that the bulk of your investment usually goes to the biggest stocks.
• Too much choice – not all indexes will perform well and the various choices available will suit different types of investors. The range of options can feel overwhelming.
• Risk – like with any investment, there’s no guarantee your money will grow and you may get out less than what you put in.

 

What’s the difference between an index fund and an ETF?

The biggest difference is that you can find ETFs (exchange-traded funds) on stock exchanges and multiple investing platforms. This means that ETFs can be bought and sold throughout the day, based on live prices – just like stocks or shares. Whereas an index fund usually has a set price determined at the end of each day.

When you’re investing over the long-term, this won’t make much of an impact. The various names of investments can create a lot of confusion. But, for all intents and purposes, you can think of most ETFs as index funds.

Sometimes you’ll also find that you can only buy certain index funds direct through a platform, but the ETF version can be found with multiple brokerages.

For example, some Vanguard index funds can only be bought with a direct account. But, you can usually buy shares in an ETF version of the same fund somewhere like eToro or Freetrade.

 

Are index funds a good investment?

Yes! Although, it depends on which fund you choose to invest in.

Over the long-run, it’s been proven time and again that index funds often outperform actively managed funds. And, they’re cheaper – which means you get to keep more of your returns, instead of paying them out in fees to a greedy fund manager!

Past performance doesn’t dictate future results, but index funds have provided excellent returns to patient investors:

• S&P 500 – 10.5% average annualised return (from 1957-2021)
• FTSE 100 – 7.75% average annualised return (from 1984-2019)

You might wonder why people even bother to invest in something like the FTSE 100 instead of the S&P 500, well here’s why:

• There’s lower capital growth but the FTSE 100 pays a much higher dividend which is better for investors looking for income.
• The FTSE 100 is less volatile, which gives investors more peace of mind.
• America has had a booming economy that gave birth to some massive companies, but their dominance may not continue forever.

So, when investing, it’s not all about which index funds have grown the most in the past. You should find the trackers that suit your goals and style of investing.

 

Which is the best index fund?

Unfortunately, there’s no ‘one-size-fits-all’ answer. The best index fund for you will depend on your goals, your investing strategy, and your tolerance for risk.

The options you can access through your brokerage platform may also limit your choices.

That being said, here are some tips for finding excellent index funds:

• Choose low fees – some funds track the same indexes, but have different fees. At the end of the day, you’re often investing in the same shares – so lower fees are better.
• Stocks and shares ISA compatible – some funds won’t be eligible for this tax wrapper. By choosing index funds that you can put into a stocks and shares ISA, you’ll pay no tax on gains, which is great for long-term growth.
• Select a few funds – each index will track a different list of investments. Although there’s some in-built diversity, you can use a bunch of different funds to create a diversified portfolio.
• ESG – if you care about the impact of your investments, look for ethical index funds or ones with ‘ESG’ in the title. They’re not perfect but it’s a good place to start.
• Global tracker fund – if you’re completely frozen by analysis paralysis, consider using a global tracker that invests in a selection of top companies from across the world.

 

What are some examples of popular index funds?

The right fund for you will be specific to your own goals and circumstances. But, to give you some inspiration, here are some of the most popular index funds and ETFs for UK investors:

• Vanguard FTSE Global All Cap Index Fund
• iShares Core S&P 500 UCITS ETF
• Vanguard US Equity Index Fund
• iShares Core FTSE 100 UCITS ETF
• Vanguard ESG Developed World All Cap Equity Index Fund
• iShares NASDAQ 100 UCITS ETF
• L&G Global Technology Index

 

How do you invest in an index fund?

The process will vary depending on the platform you use, but here are some simple steps for buying an index fund:

1. Choose which index you’d like to track.
2. Select the fund you want to invest in that tracks that index.
3. See if your investment platform has that fund available.
4. Check if the fund or ETF is ISA-compatible.
5. Either invest a lump sum or regular amounts.
6. Occasionally check-in and adjust your portfolio if your goals change.
7. Keep investing as often as you can over the years.

If you don’t have an investing account set up already, you can do so with reputable brokers such as:

• eToro
• Interactive Investor
• Hargreaves Lansdown
• Freetrade
• AJ Bell

 

What are some alternatives to investing in index funds?

When it comes to investing, this isn’t your only option. Here are some alternative ways to invest:

• Robo-advisors – if you prefer a managed approach, you can use a robo-advisor platform to build you a multi-asset portfolio for a small fee.
• Investment trusts – when you buy shares in investment trusts, you can select specific market niches and then have experts manage the investments held in the fund.
• DIY stock picking – choosing individual stocks and shares allows you the opportunity to build a DIY portfolio from scratch, managing investments yourself.

Whatever type of investor you want to be, you have loads of choice these days! Index funds are a great place to start investing and you can always adjust your strategy as you learn more about the markets.

You can also keep up to date with the latest investing news and insights by signing up to our fortnightly Investing Newsletter!

This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.