What is an Index Fund?
Index funds are a broad category of funds designed to track some underlying index. An index could be anything from ‘the world’ to ‘global e-sports’ or ‘chinese mining’. It is just a collection of companies. An index simply measures the performance of a basket of securities intended to replicate a certain group in the market.
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.
There is an index for just about everything; bonds, stocks, property, and even cryptocurrencies, even onions! Many assets have several indices covering them, owned and maintained by different index providers.
Why Index Funds?
Picking winners is hard. This has been proven time and time again throughout history. Even fund managers often fail to beat or even match their indices (benchmarks). Index funds don’t try and find the needle in the haystack. They buy the haystack.
It’s worth noting that it is very possible to outperform indices over a given time scale and given the large number of active funds statistically some will do so. Over the years some fund managers have become well known for having done so, and a small number have even managed it with some long term consistency.
Almost all, however, fail to beat the market consistently (especially after their hefty fees) or, crucially, predictably in advance. 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 here and it is strongly suggest you read it – it’ll help you understand the concept of Opportunity Risk, the risk that doing one thing with your money will be worse than doing something else with it.
You may see people refer to “buying an index”. An individual investor can’t actually buy an index directly. Instead, you buy a fund that ‘tracks’ that index. The fund will aim to replicate the returns of the index, and one important measure of a fund’s success is its “tracking error” (the lower the better). One of the major sources of tracking error is the management fees charged by the fund, but for index funds these fees are typically fairly low.
For example, imagine buying one share of every publicly-listed company in the UK (thousands of companies!). Whatever happens to the UK markets in a given day will be replicated amongst your holdings. This isn’t always exactly what index funds are doing, but the specifics don’t matter too much – the point is that rather than trying to pick which companies will do better than the rest, just buy one of everything.
Does buying one of everything seem a bit odd? Well… Over time due to many factors the market as a whole tends to rise more than it falls – inflation, technology advancement, productivity gains, population growth, and more. Again, exceptions exist, but they’re edge cases and not so applicable when it comes to global diversification.
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.
With what is hopefully a succinct introduction to the what and the why, let’s move onto the reality.
Which Index Fund(s)?
As mentioned earlier, index funds can be either mutual funds or exchange-traded funds. Your first choice is picking one (or both, if you wish) of the types, however…
This choice is heavily intertwined with which broker you use. Some brokers offer shares (and therefore ETFs) but not funds. Some offer funds only, and some go further and offer their own funds only! Some offer funds and shares and you can hold both types in one account. Accounts available and fees charged differ among brokers, so do keep that in mind when deciding what you want in your portfolio and how much you’re willing to pay for it. Other factors do go into choosing a broker, such as ease-of-access, stock/fund universe size and content.
Characteristics of Mutual Funds:
- Price doesn’t change during the day. Mutual funds price once per day at their ‘valuation point’ (often between early morning and midday). The price of a mutual fund is always the unit price of the underlying holdings – for that reason there is never a discount or premium on a mutual fund.
- E.g. A fictional index of Microsoft and Apple exists. Microsoft’s share price is 200 and Apple’s is 200. The mutual fund’s price on that day will be 200- (200+200)/2, or (MicrosoftPrice+ApplePrice)/NumberOfCompaniesHeld. This is a vast simplification of pricing a mutual fund (many, many more companies, all with different share prices, market caps, free floats etc), but illustrates the basic concept well enough – that it is an exact value, with no room for arbitrage.
- Mutual fund purchases take several days to ‘settle’ (land in your account). When you place an order you’ll not actually know the price you’re getting – you’ll get the price at the next valuation point. The trade will take a few days after that to settle, during which the price will change, but you will get the price at the valuation point after you placed your trade.
Characteristics of Exchange-Traded Funds:
- Prices live during market opening hours.
- This means there can be a discount or premium on an ETF, however it’s very unlikely and corrected very quickly should it happen:
- Discount: fund is cheaper than buying all the holdings inside it, sell the holdings and buy the fund for a profit, therefore someone does that and buying the fund raises the price due to increased demand.
- Premium: fund is more expensive than all the holdings, sell the fund and buy the holdings for a profit, someone does that and the increased supply of the ETF reduces price.
- In reality this is not even worth thinking about for ETF index investing, but it’s an interesting point nonetheless, and will pop up again for Investment Trusts (out of scope for this article!)
Below is a list of common funds and ETFs. These tables and their contents are not given as financial or investing advice and are solely provided as examples. The funds within are in no particular order. Links are to Hargreaves Lansdown, a fund supermarket. This is not a recommendation to use or not use Hargreaves Lansdown, they just have a very clean site with easily-found information on each fund.
|Fund||Fee (Fund only)||Index||Notes|
|Fidelity Index World P||0.12%||MSCI World Index|
|Vanguard FTSE Global All Cap (Income)||0.23%||FTSE Global All Cap Index||Income version of below fund, pays dividend annually|
|Vanguard FTSE Global All Cap (Acc)||0.23%||FTSE Global All Cap Index||Accumulation version of above fund, dividends aren’t paid as cash but accumulate into the fund.|
|HSBC FTSE All-World Index (Income)||0.19%||FTSE All-World Index||Income version of below fund, pays dividend annually|
|HSBC FTSE All-World Index (Acc)||0.19%||FTSE All-World Index||Accumulation version of above fund, dividends aren’t paid as cash but accumulate into the fund.|
|ETF||Fee (Fund only)||Index||Notes|
|Vanguard FTSE All-World (Income)||0.22%||FTSE All-World Index||Quarterly dividends paid as income.|
|Vanguard FTSE All-World (Acc)||0.22%||FTSE All-World Index||No income paid out, accumulates within the fund.|
Monevator list of index funds
A comprehensive list of index funds exists over at Monevator, which covers a greater number of indices than we do here.