If you’re looking to start investing for the first time to give your money a boost, index funds might be the right investment decision for you.
Index funds can provide a solid base to an investing strategy, particularly for novice investors, as they tend to be low-cost, low-hassle, and fairly passive funds.
In this beginner’s guide to index funds, you can find full details of what they are, how they work, how to invest in them, and the fees you might typically have to pay.
Understanding mutual funds
Index funds are actually a type of mutual fund. That’s why you need to understand the concept of a mutual fund before you can fully understand what an index fund is.
A mutual fund essentially allows you to “pool” your money together with other private investors.
Rather than buying shares in a company individually, you can invest your money into a fund that holds a range of equities instead.
The fund itself can contain hundreds of different stocks and shares, with your future returns dependent on how these companies perform.
You then receive returns from the fund based on how well the selected stocks and shares performed, and how much you have in the fund.
Investing in a range of stocks and shares
These funds can be useful as you only have to make a single investment to have a diversified portfolio of different stocks and shares.
This makes them convenient, especially for new investors. Rather than you having to buy lots of shares in individual companies, you can access a wide range of different stocks and shares through one fund.
It also means they’re fairly cost-effective compared to buying individual stocks and shares, as you only have to pay any commission on that single investment, rather than paying a commission on each individual stock or share purchase or sale.
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How much will I pay to invest in an index fund?
The amount you’ll pay to invest in an index fund will vary, depending on the investment platform you invest through and which investments are included.
Currently, Vanguard Investor offers index funds with fees as low as 0.06% of invested funds. However, some more specialised funds may ask for as much as 0.5%.
What is an index fund and how is it different?
An index fund is a type of mutual fund, except it uses a slightly different method of choosing its holdings.
In principle, an index fund is the same as a mutual fund, in that it’s a basket of investments you can invest in, rather than buying individual investments.
However, the investments within an index fund are based on a specific stock market index, aiming to emulate the same level of return that the particular index itself generates.
For example, a fund might contain all the investments from an index such as the FTSE All-Share Index, or the FTSE 100 Index.
This means when you make an investment in the index fund, you invest in all the companies contained in that particular index.
So, if the FTSE 100 went up by 4% in one year, the index fund you’ve invested in should be giving you the same level of returns.
Index funds literally track the performance of the index they follow. That’s why you may sometimes hear index funds referred to as “index tracker” funds, “index trackers”, or just a “tracker” fund.
Index funds are available in other countries and their financial markets. So, if you want to invest in US stocks and shares, you should be able to find an index fund that tracks the Nasdaq or the S&P 500.
Index funds are passively managed funds
One big difference between mutual funds and index funds is that index funds are “passively managed” funds. That means rather than paying fund managers to invest your money for you, the fund follows a pre-set formula to determine what it invests in.
As a general rule, passive investing in this way is typically associated with lower fees, as you don’t have to pay a manager to pick investments for you.
Therefore, it may present a cheaper option for you as an investor.
How are passively managed and actively managed funds different?
The difference between a passive fund and an active fund is in the name: active funds are proactively managed and adjusted by a manager, whereas passive ones are left to track their selected index with no further input.
As a result of having an active participant there to manage the investments, active funds tend to be more expensive than passive ones.
You might think that having a specialist fund manager might lead to better returns. If an expert is buying and selling shares on your behalf, surely they know when to buy and sell to generate the maximum return?
The answer is: no, not always.
In times of flux, stock market volatility, and economic turmoil, professional fund managers often come into their own. The decisions they make with an active fund can help protect them from unpredictable market movements, ensuring they still provide a return to their investors.
However, interestingly, passive funds (like tracker funds) have historically performed better than actively managed funds. Funds that simply track a wide index – like the FTSE 100 – have often generated better returns than so-called “star” fund managers.
Index tracker – the risks
While an index tracker fund can be a simple and cost-effective way to invest, you should bear in mind that all stock market investments come with an element of risk.
Stock markets can be volatile, so even investing in 100 or 250 of the biggest companies in the UK can be risky. The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Most experts suggest that if you want to invest in the stock market, you should consider a minimum time frame of five years.
Disadvantages of index funds
There are a few downsides that you should be aware of when investing in index funds.
You’re entirely at the mercy of the stock market
Without choosing your own investments or having a manager to check them for you, the performance of index funds is entirely dependent on the wider market.
As a result, you may end up taking on more risk than you’re comfortable with by investing via index funds.
For example, think back to the Covid-induced recession from March 2020.
On 21 February, the FTSE 100 was valued at 7,403.92. But, by 20 March, it had fallen to 5,190.78.
Similarly, the FTSE All-Share fell from 4,132.71 to 2,837.05 in the same period.
However, if you had money invested in funds tracking either of these indices, you could have quickly lost value.
Of course, many global stock markets have recovered in 2021 thanks to the rollout of the Covid-19 vaccine and the reopening of the economy. However, if you’d decided to cash in your tracker funds after the market dip, you could have lost money.
There’s also the potential for something known as a “tracking error”.
This is where the value of the fund doesn’t match up with the value of the index it tracks. This can lead to an unexpected profit or loss that shouldn’t have occurred.
As index funds are passively managed, this increases the risk of a tracking error occurring, as there’s no fund manager there to actively keep an eye on progress.
You can only trade once a day
Index funds only allow you to buy and sell investments in them once a day. As a result, you have less control, meaning you won’t be able to make changes quickly.
You may have to pay tax
Unless you buy index funds in an ISA, you may have to pay tax on the profits you make from your investment.
This could be Capital Gains Tax (CGT) if, when you sell your investment, the gain in value that it generates exceeds the CGT allowance – which is £12,300, as of July 2021.
As an example, if you invested £10,000 in tracker funds which grew in value to £35,000, and the funds were not in an ISA, you may have to pay Capital Gains Tax on some of your profit.
Aside from mutual funds and index funds, there’s also another option called an “exchange-traded fund”, or ETF.
ETFs and index funds are essentially the same thing, using a passive investing strategy and tracking the performance of a specific index.
The main difference between an ETF and an index fund is that, whereas you can only trade your holdings in an index fund once a day, ETFs generally allow you to buy and sell in the market at all times.
That means that you can buy and sell your holdings in an ETF whenever you’d like. This allows you to keep up with sudden changes in the stock market.
It may give you the chance to react quicker in the event of a tracking error, too.
However, it also increases the temptation to buy and sell impulsively. As a result, they may not be suitable for all investors.
Working with a financial advisor
If you’re new to investing and want to know whether index funds are the right investment choice for you, you could consider working with a financial advisor.
An independent financial adviser can offer personal advice for you and your personal circumstances, helping you to design an investment portfolio that works for you.
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Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested.
Past performance is not a reliable indicator of future performance.
Antonia is the Financial Editor at InvestingReviews.co.uk and brings a wealth of experience, having written for various industries over the past 10 years.
Her investment platform reviews, news, blogs and guides are meticulously researched, fact checked, and updated on a regular basis.