Index funds are a broad category of funds designed to track some underlying index.
An index is a collection of companies put together by an index provider. The purpose of the index could be anything from 'a representative sample of the global stock market' to 'the 500 largest companies in the US' to 'global e-sports' or 'Chinese mining'. There is an index for just about everything; bonds, stocks, property, cryptocurrencies, even onions!
However in general when people talk about investing in 'index funds', they mean funds which track a diversified, global index. (Not onions).
Why Index Funds?
When you buy an index fund which tracks the global market, the performance of your investments will match that of the market as a whole. That includes the companies, regions or sectors rocketing up in value, and the ones whose value has stagnated or fallen over the same time period.
In theory, it would be ideal to invest only in the best performing companies, and enjoy higher returns. However, picking these winners in advance is very hard, even for professional fund managers. It is so hard that almost all of them fail to beat the market consistently in the long run (especially after their hefty fees). This has been well studied and proven time and time again – see our Recommended Resources for some books on the topic.
It's entirely possible for stock picks (whether directly or through an actively managed fund) to beat the index. In fact, given the number of stocks and funds out there, it's a statistical certainty that some of them will be beating the global index at any given point. However, a fund beating the index over the last 3 years doesn't give you any meaningful indication about whether it will do so over the next 3 years, when you have your money in it. Some "superstar" active fund managers have crashed and burned spectacularly with huge losses for investors despite years of outperforming their indices.
This is a critical point – picking winners works until it does not, and there's no knowing when that time will come. A regular contributor to /r/ukpersonalfinance posted a very detailed review of his own experiences of investing outside of index funds and it is strongly suggested you read it.
What drives the growth?
If you're used to thinking of investing as picking the best companies or timing your buying and selling, buying a fund which invests in 'a bit of everything' and holding it for years might not sound like what you think 'investing' is about. However it's actually the strategy with the best evidence behind it.
The reason it works is that over time, the market as a whole tends to rise more than it falls. This is due to many factors – inflation, technology advancement, productivity gains, population growth, and more. Exceptions exist, but they're very rare. By buying 'the world', you ensure you don't miss out on any big success stories happening anywhere.
There's very often another benefit to index funds. Due to their simplicity – a single, unchanging aim of tracking their index – they are almost always cheaper than actively-managed funds. We have a page on why fees matter here – small differences in fees matter a lot over decades.
Which Index Fund(s)?
Choosing a fund to invest in can be daunting. There are a number of different indices, fund providers, and types of funds out there.
Which index (or indices) to use
If you're just starting your portfolio, the easiest option is to pick one index which covers a globally diversified set of investments. A global, all sector, all capitalisation fund provides the maximum amount of diversification available.
There are multiple global indices available from different index providers, with some small differences between them such as how many companies are included in the index, the weightings given to different regions, etc.
Examples of popular global indices are: the FTSE All-World, Global All-Cap, and MSCI World Index.
Note that if your portfolio is over £100k, you may prefer to build a global index tracker yourself using component funds, as at this scale it will be slightly more cost-effective than a single fund.
Selecting a fund
Popular indices such as the ones above may be tracked by multiple different funds, run by different fund managers.
Here are some factors to consider when choosing which fund to invest in:
One important measure of a fund’s success is its "tracking error". This is a measure of how accurately the fund is able to track its index (bearing in mind that the index is on paper only, but a fund tracking it has to actually buy and sell holdings as people invest money in the fund or companies move in and out of the index). The lower the tracking error, the better.
One of the major sources of tracking error is the management fees charged by the fund. You can read more about the impact of fees here, but note that for index funds these fees are typically fairly low.
Acc vs Inc
At the end of the fund name you'll see either 'Acc' (accumulation) or 'Inc' (income).
Accumulation funds automatically re-invest any dividends issued by the companies the fund invests in. Income funds will pay them out as cash into your account.
If you are investing within a S&S ISA (including S&S LISAs) or pension, it's easiest to use accumulation funds to fully benefit from compound interest. If you are investing in a general (taxable) account, using income funds makes tracking your tax liabilities easier.
OEIC vs ETF
Index funds can be either open ended funds (also known as: mutual funds, OEICs or unit trusts) that are traded by your broker at fixed daily points, or Exchange Traded Funds (ETFs) that can be traded instantly when markets are open, much like normal stocks. Both do basically the same job for long-term investors, but if you're interested in the topic, see the funds FAQ for more detail.
You may find that your broker has different charges for the two types of funds.
List of commonly used global index trackers
Below is a list of common funds and ETFs.
|Fidelity Index World P||OEIC||0.12%||MSCI World Index|
|Vanguard FTSE Global All Cap (Acc)||OEIC||0.23%||FTSE Global All Cap Index|
|HSBC FTSE All-World Index (Acc)||OEIC||0.13%||FTSE All-World Index|
|Vanguard FTSE All-World UCITS ETF||ETF||0.22%||FTSE All-World Index|
A comprehensive list of index funds exists over at Monevator, which covers a greater number of indices than we do here.
You can also view a list of global index trackers at trustnet.
What about Vanguard’s LifeStrategy funds?
Vanguard's LifeStrategy fund series are designed as a one-stop-shop for a portfolio that is partially equities and partially bonds, in some fixed ratio. E.g. the LS80 fund has 80% equities and 20% bonds, and the LS40 fund has 40% equities and 60% bonds.
The equities portion of the LS funds doesn't track an index, but it is made up of a set of component funds for different regions (US equities, UK equities, etc). This achieves much of the same purpose.
However it should be noted that the LS funds 'overweight' UK-based investments – meaning the UK takes up a bigger proportion of the LS funds equity portion (20%) than it does in an index weighted by market capitalisation (the UK makes up just under 5% of the global stock market). This is known as a 'home bias'. Some investors prefer to invest more heavily locally, others prefer to keep it passively global.
You can read more about this in Vanguard's whitepaper on global equity investing.
(the tl;dr of the whitepaper is that a slight home bias is unlikely to make much difference in the long-term).
What about the S&P 500?
The S&P 500 is an index of 500 of the largest companies in the US. If you read American personal finance resources, you'll often see this as a recommended investment.
Although the US makes up around 50% of the world’s stock markets, by investing exclusively in the S&P you’re also missing out on the other 50%.
I don’t know which one to pick, should I buy some of each?
When faced with a bunch of good options, it's a natural impulse to want to split the difference. However this is not necessarily a helpful strategy.
Remember that the number of funds you invest in doesn't necessarily increase your diversification. It's what those funds are invested in that counts.
If you invest in two extremely similar global index funds, your portfolio's performance will not be significantly different compared to selecting one or the other. You have added admin complexity for no gain (and perhaps at a cost of higher fees, if your broker charges per trade).
If you are considering splitting the difference between two investments with more significant differences, such as between a global index and a LifeStrategy fund, take a step back and look at your portfolio as a whole, and think about why you want both funds.
For example perhaps you want the global index fund because you've read about the benefits of a fully passive approach. But you've also been persuaded that a bias towards UK investments has some merit.
If you combine the LS100 (20% UK) and Global All-Cap (4.5% UK) funds in equal amounts, you now have a portfolio which has an average of the two – 12.25% UK. Imagine for a moment that this combined fund was offered on the market. Would you think 'brilliant, 12.25% UK, that's exactly what I wanted, I can just buy that and I'm done'? Or would you still be looking around to see if there are any other 'good' funds to add to your collection?
It's not that 12.5% UK is a bad or dangerous amount to have in your portfolio. What matters is that you are confident that you have a sound rationale for your selection, so that you're not tempted to keep buying and selling to chase better returns.
It's also worth knowing that as with any multi-fund portfolio, if you want to maintain a particular ratio between the funds, you will need to periodically re-balance as some will grow faster than others.