What are index funds and how do they work?

Index funds, also known as index trackers, are investment vehicles designed to replicate the performance of a specific market index.

In recent years, index funds have gained significant popularity in the investment world and are considered a key component of passive management strategies. These funds offer several advantages, such as simplicity, transparency, diversification, and notably low costs.

This article aims to provide you with a comprehensive understanding of index funds. We'll delve into what index funds are, how they operate, essential factors to consider when investing in them, and practical steps on how you can get started. So, let's dive right in!

What is an index fund?

Index funds are investment vehicles designed to replicate the performance of a specific reference index, often based on stock indices such as the FTSE 100 or S&P 500.

The philosophy behind index funds is grounded in passive management. Extensive research has demonstrated that only a small number of investors and investment funds consistently outperform their respective reference index over the long term. Index funds embrace this notion by simply copying or replicating the chosen index, essentially mirroring the overall stock market.

Rather than actively searching for the best-performing stocks and trying to time the market, the strategy of an index fund is to closely imitate the index's composition. Consequently, these funds remain fully invested in the entire market.

It's important to note that index funds do not aim to generate excess returns or outperform the market; instead, they strive to achieve a return as close as possible to that of the index they track. As a result, investors in index funds should not expect returns higher than the overall market.

One significant advantage of index funds lies in their comparatively lower costs when compared to traditional actively managed funds. Replicating an index demands less effort and resources than pursuing an active investment strategy, leading to reduced expenses for investors.

Are index funds the same as ETFs?

Both index funds and ETFs form the foundation of passive management, but they are distinct financial products.

An index fund operates as an investment fund in every aspect and functions similarly to traditional funds. Conversely, an ETF, also known as an exchange-traded fund, operates like a stock listed on the exchange.

An ETF can be bought and sold at any point during trading hours, akin to regular stocks, whereas an index fund is bought, sold (redeemed), or transferred at the end of each trading day, much like other conventional funds.

What both index funds and ETFs share is their objective of replicating indices and maintaining very low costs while doing so.

How index funds work

The way an index fund works is the same as any other mutual fund. When investing in an index fund, you acquire a certain number of fund shares, and their value will fluctuate based on the performance of the underlying reference index they track.

As a participant in the fund, you have the flexibility to purchase additional shares, sell them (redeem), or transfer them to another fund, just as you would with a conventional fund.

Types of index funds: physical or synthetic

Index funds can employ two primary methods to replicate their respective index: physical or synthetic replication.

Physical funds invest directly in the stocks or bonds that constitute the index. In other words, they own the actual assets. On the other hand, synthetic replication funds use derivative contracts, typically swap contracts, to mimic the index's performance. These funds do not directly hold the index's stocks.

These two approaches represent the main categories of index funds based on how they replicate their target index. It's worth noting that physical replication funds can be more volatile, but they offer greater transparency.

Features of index funds: advantages and disadvantages

Now that you have a clear understanding of what index funds are and how they function, let's explore the pros and cons of this investment product. By examining these aspects, you'll gain a deeper insight into what index funds can offer you.

Advantages of investing in index funds

✅ Low cost: Index funds adopt a passive approach by tracking an index, resulting in lower management costs compared to actively managed funds. Managing an index fund requires fewer rebalancing trades (i.e., only if the components of the tracked index change), leading to reduced costs. This, in turn, translates into higher additional profitability for the holder. It's essential to remember that any extra fees you pay directly impact your overall returns.

Requires little financial knowledge: Investing in indices is relatively easier compared to creating an investment portfolio on your own. You don't have to analyse company by company, sector by sector. The passive strategy itself is much simpler and easier to understand than the analysis of individual companies or investment funds. It is based on copying the market and the main work you will have to do is to determine how you distribute the portfolio (how much you invest in equity and fixed income and in which geographical areas).

Comfort and diversification: The portfolios of index funds are made up of thousands of companies, so it would be very difficult to replicate them individually. To put it into perspective, an index fund to the MSCI World Index invests in more than 1,500 companies from the 23 most developed countries in the world and covers about 85% of the market capitalisation of each of them. With a single product, your portfolio will be more diversified than it could be by buying stocks individually.

It's easier to manage: Investing through index funds is simpler and takes considerably less time than creating your own portfolio of stocks or investment funds. As we mentioned, the main work is to decide the asset allocation. After that, you will only have to take care of the rebalancing and that is if you do not opt to invest with a robo-advisor.

Affordable investment limits: Index funds are affordable and very accessible. Although there are some with high entry limits, it is usually possible to start with little capital.

Profitability: Index funds have yielded better results than active management in the long term.

Disadvantages of investing in index funds

Lack of protection against losses: There is no loss limit, but this is intrinsic to any type of investment. Unlike investing individually in assets, you don't control the risk.

Volatility: When investing in the entire index, the portfolio can and usually is more sensitive to market movements than a stock portfolio or an actively managed fund.

Established investment portfolio: No company can be added or removed. The changes in the fund's portfolio will depend on the index it tracks. In other words, if you invest in an index fund tracking the S&P 500, you will be buying the 500 stocks of the index, no more, no less. However, you can still invest in other funds or assets separately.

You can't beat the market: Your return will always be lower than a benchmark index and, in any case, it will be capped at what the market achieves. The reason is that the index return will be reduced by the fund's costs.

Long-term performance: Indexing is a strategy that offers better results in the long run, specifically for periods of more than 10 years.

How to invest in index funds?

You can invest in index funds on your own or through a robo advisor. With the first option, you will be the one who takes care of everything, while with the second you will be advised by an investment app, platform, or brokerage.

Investing through a robo-advisor

A robo-advisor is an excellent option for beginner investors or individuals who prefer to avoid the complexities of selecting individual stocks, bonds, ETFs, and other assets. Despite its name, a robo advisor is not a robot – it is a platform, brokerage, or an app designed to help you participate in financial markets automatically.

Of course, the convenience of robo-advisors is also the main drawback. As the investment comes with professional management, you have very little, if any, control over your portfolio.

The main robo advisors in the UK are:

  • Moneybox
  • InvestEngine
  • MoneyFarm
  • Wealthify
  • Chip

Choose your own assets

If you possess a clear understanding of which index fund you wish to invest in and have the time and resources required, managing your own assets might be the right option for you.

Funds are available from many brokers. Opting for a self-managed portfolio of index funds entails some effort on your part. Here are the key points to consider:

  • You will have to determine your investor profile.
  • You will have to design the asset allocation, key to determining the risk of the portfolio.
  • Regularly adjust your portfolio to maintain the desired asset allocation. The weights assigned to fixed income and equities may change over time based on their respective returns.
  • You will have to dedicate some time to managing the portfolio and staying up to date with market news.

In return, you will save on the management fee of the robo advisor, which normally depends on your capital.

How to choose the best index fund?

If you're uncertain about which index fund to invest in, consider the following five key factors to help you make an informed decision.

1. Choose the asset class in which you want to invest and look at the availability of index funds. Your brokerage platform or reputable websites like MorningStar are good places to start.

2. Compare commissions, history, and currencies: when comparing funds with similar characteristics, opt for the one with the lowest expenses.

3. Compare the fund's performance with that of the index it replicates. A significant difference indicates that the manager might not efficiently replicate the index, making it less suitable for your indexing needs.

4. Evaluate the liquidity of the fund. A higher liquidity level in the fund indicates that it is easier to sell your position. The size of the index fund is one way to assess its liquidity.

5. Consider commissions and other costs. Some brokers or other service providers may charge you commissions and multiple other fees. Make sure you select your provider based on a thorough analysis.

Index fund or ETF?

When opting for a passive, long-term investment strategy, both ETFs (exchange-traded funds) and mutual fund are suitable.

Both index funds and ETFs have distinct characteristics, and the most significant differences that influence the decision to invest include:

  • Availability and liquidity: ETFs have a more extensive and specialised range of offerings compared to investment funds. While most index funds replicate broad stock indices, ETFs can also track specific sectors and industries. Additionally, the operation of an ETF is more flexible and agile because it functions like a stock, making it easier to buy and sell throughout the trading day.
  • Cost differences: ETFs usually have a lower management fee (only applicable in the case of passively managed ETFs).

The choice between an index fund or ETF may also depend on the following characteristics:

  • Index selection: It's possible that for the specific index you want to track, only one of the two options (index fund or ETF) is available.
  • Investment style: Make sure you check the fund's prospectus and understand the investment strategy, objectives, composition, and other details before investing.
  • Liquidity and brokerage costs: examine the availability of brokers, such as the best ETF brokers before getting started, and choose the one that offers the most convenient cost structure (such as the best commission-free brokers).

Have a look at our index funds vs ETFs article to learn more about the differences between the two types of funds and which one suits you best.

Read more about funds

Index funds summary

In this comprehensive article, we delve into the world of index funds, exploring how they work, their advantages and disadvantages, and factors to consider when choosing between index funds and ETFs. Whether you're a beginner investor or seeking to optimise your portfolio, we provide valuable insights to help you make informed decisions and navigate the realm of passive investing.

Index Funds FAQs

What are the main advantages of investing in index funds?

Index funds offer numerous benefits, including low costs, simplified management, broad diversification, and historically superior long-term returns compared to active management strategies.

How do I choose the best index fund for my portfolio?

When selecting an index fund, consider the index you want to replicate, compare commissions, assess the fund's historical performance and tracking error, evaluate liquidity, and look for options without additional commissions.

What are the key differences between index funds and ETFs?

Index funds operate like traditional mutual funds, while ETFs function like stocks, offering more specialised investment options.

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