Index funds explained
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If you’re new to investing and are thinking about investing in funds, you may have already come across index funds as an option. However, if you don’t completely understand what index funds are, you’re not alone. On this page, you’ll learn everything you need to know about index funds, how they work and some pros and cons to help you decide if this investment strategy might be right for you.
An index fund is designed to match and mimic the performance of a financial market index
Similar to mutual funds, an index fund allows you to invest in a pool of money to purchase assets in the stock market
Index funds match the risks and returns of the stock market index they are tracking, which can be beneficial for long-term investments
What’s an index?
An index reflects the performance of a basket of securities of a stock market. In financial markets, indexes can include stocks and bonds and reflect the performance of a particular market.
Each index has its own composition An example of an index is the FTSE 100, which tracks the 100 largest companies in the UK.
What is an index fund?
An index fund is a passive mutual fund or exchange-traded fund (ETF). It has a portfolio that is constructed to match a specific financial market index. Index funds typically offer broad market exposure and have low operating expenses.
Index funds deliver the same returns as the chosen index, meaning that if the tracked market index increases, then the value of the shares in the fund will also increase, and vice versa, if the market decreases.
If the index was the FTSE 100, for example, this is what the last five years of increases and decreases in the value of your index fund would look like:
How do index funds work?
Since index funds are a type of passive mutual fund, when you purchase shares in an index fund, you’re simply adding your money into a pool along with other investors to purchase assets that duplicate the performance of a chosen index.
In this way, index funds are passive funds, in that they track the stock market to gain returns that are in line with the current stock market price.
What are the pros and cons of index fund investing?
Pros
- Index funds tend to offer better returns than actively managed funds over a long period of time.
You’ll usually find that index funds offer lower fees, because the portfolio rarely changes, which means they have lower trading costs.
- Index funds offer transparency because they track a specific index. This could allow you to judge the index fund’s risks better compared to intransparent active funds.
- It’s easier to diversify your financial portfolio, because you’re effectively buying slices of lots of companies at once. This diversity means you’re minimising the risks of investing.
Cons
- Index funds can lack flexibility, because they track and stick specifically to an index. A fund manager cannot sell underperforming stocks.
- Since index funds mimic and track the performance of a specific index, they cannot outperform the index to acquire better returns.
- The difference between the return you’ll get from an index fund and the performance of the index it’s tracking is the reflection of the cost to run the fund. This is known as tracking error, and it can be used to compare index funds.
What should I consider when choosing an index fund?
The main factors you need to consider when investing in an index fund are your goals and how much risk you’re comfortable with, the fees you’re willing to pay and the length of time you’re willing to invest your money for. Deciding on these factors can help you determine if an index fund is for you.
What are the risks of investing in an index fund?
These are the typical risks of investing in an index fund:
- They lack protection: as you can see from the graph above, the stock market has its ups and downs. This means that when you invest in an index fund, you can see great returns when the market is doing well, but equally, it can leave you vulnerable when the market is down.
- Lack of flexibility: index funds don’t allow you to change the index you’re tracking. If you feel that the index your fund is mimicking is going to decrease in value, you can only sell, but not act to change its course, regardless of having that knowledge.
- Little control: index funds don’t have a fund manager, which gives you no control over your portfolio, meaning that if the market goes down, the index fund will go down with it and vice versa.
- Investing in index funds can be stressful: especially when the market is volatile. Due to the increase or decrease in the value of your shares, you might find yourself constantly checking how the market is performing and making emotional rather than logical decisions.
Which index fund is right for me?
Which index fund is right for you depends on the type of company you might want to invest in. Index funds track various indexes, which are composed of stocks or assets that can be based on the following:
- Company size: there are index funds that track small, medium or large companies
- Geography: these index funds focus on stocks from companies in different countries or regions of the world
- Industry: you’ll find index funds that focus on consumer goods, technology or any other business sector
- Asset type: some index funds track domestic or foreign bonds, commodities or other asset classes
Examples of index funds
A good example of an index fund is the American Vanguard 500 Index Fund, which was founded in 1976, and is one of the most successful funds for long-term performance and low cost. The Vanguard 500 faithfully tracks the S&P 500, short for Standard & Poor’s 500 – a stock market index that tracks 500 publicly traded domestic companies, and is considered by many investors to be the best overall measurement of American stock market performance.
In the UK, the iShares Core FTSE 100 UCITS ETF tracks the whole of the FTSE 100 and is recognised as one of the more successful index funds.
Saving vs investing in an index fund
If you’re uncomfortable with taking risks but want to maximise your savings pot, you might want to consider investing in a high interest savings account instead.
Savings accounts such as fixed rate bonds, notice accounts and easy access savings offer competitive interest rates that you’ll receive from the day you open the account until the end of your agreed term. When your fixed term ends, you’ll receive all the money you’ve invested plus the interest you’ve earned.
If you want to quickly and easily open a savings account that can earn a guaranteed return on your investment, register for a Raisin UK Account and apply today. Opening savings accounts with competitive interest rates from a range of UK banks through our marketplace is free, and your money is always protected.