Investing in index funds is a popular choice for investors worldwide, especially beginners. In fact, there’s over £5 trillion invested in Vanguard’s index funds alone. In a nutshell, an index fund is a low-cost portfolio of shares or other assets (like bonds) that tracks an industry benchmark or market index.
Here’s a simply step-by-step guide explaining how you can start investing in index funds:
Index funds are collections of stocks that are designed to reflect the companies that are listed in a specific index. By investing in an index fund, you get exposure to each stock in the fund, without having to go through the process of buying each stock individually.
Index funds are often passively managed, which basically means not much work goes into maintaining them. The benefit of this is that it can lead to lower investing costs which (should) get passed on to you. So, index funds provide a cheap and simple way for you to invest in a whole basket of stocks with minimal oversight.
When you invest in an index fund, you purchase a stake in all the companies that the fund holds. When stocks in a fund change, for example if a stock moves out of the index and another moves in, your holdings change too. Stocks move in and out of indices regularly, so your index fund will automatically rebalance and reshuffle to reflect any changes.
While you could get exposure to all of the stocks in an index by buying shares in each company, buying an index fund could save you time, effort and (potentially) money. Not only is it quicker to buy a fund, you also don’t have to worry about selling and buying stocks to reflect changes in the index.
Plus, if you wanted to buy shares in say, every company on the FTSE 100, you’d have to pay a commission for 100 trades, which could set you back hundreds of pounds. When you buy a fund, you pay a single, annual fund management charge.
A stock index is a collection of stocks listed on the stock exchange. In the UK, the most well-known stock index is the FTSE 100 (pronounced footsie one-hundred). “FTSE” stands for Financial Times Stock Exchange. In short, it’s the 100 biggest companies listed on the London Stock Exchange (LSE).
There are loads of different stock indices, such as the FTSE 250 and the S&P 500. Investors use these to get a general picture of how healthy the market is. The values of stock indices tend to rise and fall depending on economic indicators and company news. When the economy is doing really well, its stock market indices will rise in value, as investors feel confident. The opposite is also true. If investors are feeling less confident about their investments, they might decide to sell. If everyone is selling, the price will decrease. A great example of this is the sudden crash in the stock market shortly after COVID-19 was declared a pandemic.
Take the HSBC FTSE 100 Index Fund. As of April 2023, it invests in 106 assets, made up of 96.94% in equities (company shares), with the remainder in cash, property, investment trusts and other assets.
The fund holds all of the companies that make up the FTSE 100 Index in similar proportions to which they are included in the index. Sometimes, it might not hold all of the companies. This would typically be to manage costs or characteristics or if there are any restrictions.
For example, here are the top 10 holdings of the FTSE 100, compared with the top 10 stocks in the HSBC FTSE 100 Index Fund, as of the time of writing.
As you can see, the top 10 stocks in the index fund are the same overall as the top 10 in the index itself, though the ranking is slightly diffferent.
The purpose of an index fund is to match the performance of the index, not beat it.
This is for you to decide. The best index for one person to invest in might not be the best for another. So, as with all investing, it’s a case researching and choosing the index (or indices) that best aligns with your investment goals, strategy, and risk appetite.
What we can do is give you an overview of some of the world’s leading stock indices popular amongst index fund investors, these include:
This is only the tip of the index iceberg. There are many more, so you’re bound to find one that suits you. And for every index, you’ll also have a choice of index funds to invest in. This choice will often come down to which ones are available via your chosen platform, and what the fund costs are.
There isn’t a single overall average index fund return, because it varies by index. Plus, averages can be a bit misleading, disguising some big variations. Returns depend on the timeframe you’re looking at.
Nevertheless, holding an index fund or ETF for the long term is often the best strategy. Investment volatility typically evens itself out and results in positive returns over time, which is why we often bang on about the importance of investing for the long term.
The returns from an index fund won’t be quite the same as those of an actual index. But it should mirror it pretty closely (excluding fees).
The value of your investments could fall, as with all investing. However, index funds are considered relatively low-risk, compared with buying shares in a company. One reasons is because of diversification. Index funds can be made up from many different investments. By investing in an index fund, you’re diversifying your portfolio. This means that you haven’t put all your eggs in one basket.
Index funds are a type of passive investment. Unlike with actively managed funds, they simply mimic movements of the underlying index.
The result of this is, typically, is much lower costs for index funds than for actively-managed funds. This is one of the things that makes them so popular, particularly since index funds often perform just as well (and sometimes better) that actively managed funds.
That doesn’t mean there are no costs at all. Typically, you’ll need to pay:
Often, yes. Index funds can be a simple and straightforward option. They’re a solid building block for investors and can be easier for beginners to grasp. They don’t need much active involvement, so once you’ve picked an index fund, you can invest passively and don’t need to monitor on frequent basis. Assuming you’re planning to invest for the long-term (as all but very experienced investors should be) then index funds can be a good place to start.
While no investment is risk-free, funds can also be a lower-risk way to invest compared with buying shares or more complex investments. By investing in a fund, you’re spreading your money across a bunch of investments, which automatically diversifies your portfolio to a certain extent.
Timing the market is something that even experts struggle with, as it’s so hard to predict with any certainty what will happen next. Especially in a volatile economic environment, as has been the case in the UK in recent years (as of early 2023, at least).
The reality is that, provided you’re investing for the long term, there’s no bad time to start. The longer you have your money invested, the longer it has to ride out any volatility, grow, and help you meet your investment goals. Investing in index funds is no exception to this rule. And don’t be put off just because you’ve read news stories about the market being “down”. That just means that it should cost you less to buy investments that will hopefully rise in value when the market picks up.
Some investment providers don’t have index funds on their platform, so it’s worth making sure the one you choose to go with does have the funds you’re interested in. However, many platforms offer ETFs instead of index funds because these can be easier to access and trade.
Here are some examples of providers that will let you invest in index funds, ETFs, or both:
ETFs are a type of fund that’s traded on a stock exchange. You can get index-tracking ETFs, which are very similar to index funds except for a few things. Here are the key differences between ETFs and index funds:
Learn more about the differences between index funds and ETFs
Index funds tend to do pretty well, compared with other types of investments. There are loads to choose from, and often providers will have pre-made lists with a selection of their favourites.
Here are some of the key benefits of investing in index funds:
Despite their benefits, there are a couple of downsides of investing in index funds. In particular:
As the name suggests, index funds are made up of the companies listed within a given index. So, the performance and returns closely mimic the performance of the index being tracked. Investing in index funds can give you exposure to multiple stocks in one fell swoop. Plus, they tend to be much cheaper than actively managed funds.
Index funds and index-tracking ETFs are often considered one of the best investments for beginners because they’re straightforward, cheap, and diversified. Even for more experienced investors, choosing to invest in an index fund can provide a solid foundation for you to build from with the rest of your portfolio.
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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Can an index fund be placed in an ISA?
Hi Gilbert. Yes – we cover this in the FAQ at the end of the page: “You could invest in index funds tax free if you choose to invest in an individual savings account (ISA).”