Index funds are some of the most powerful tools that beginner investors can use to hit the ground running building a successful investment portfolio. Some successful investors go their entire investing career just investing in index funds alone, and they have pretty much always been the majority of my investing portfolio. Index funds are a great help in instantly building diversification early on in your investing life. They also reduce the amount of research and knowledge you need before you can start building up your investments.
With one purchase, you can diversify your portfolio and get access to some funds that have performed brilliantly over their history, but without the huge fees that come with active funds. The choice has gone up greatly over the last few years whilst fees have been dropping, meaning now is a great time to start looking at passive funds.
What is a stock market index?
A stock market index is a list of companies, which have been grouped together for a reason, and are tracked together. Examples are:
- FTSE 100: the 100 largest companies on the London Stock Exchange (LSE)
- FTSE 250: the next 250 largest companies on the LSE (ranked 101-350)
- S&P 500: the largest 500 US listed companies
The index is just a number that represents how well the companies in the list are doing. Generally, if all the companies in the list doubled in value, the index figure would double.
If the number goes up, the companies are doing well, if it goes down, the companies are struggling. Indexes covering a lot of a country’s large companies is often used as a measure of how well that country’s economy is doing.
What is an index fund?
An index fund seeks to replicate the results of a specific index by buying all the companies in it. You can then buy part of the fund so you get to buy a bit of each of the companies all at once.
An S&P 500 tracker for example would look to buy investments that will let it match the S&P 500 index, usually by buying the 500 shares that make up the index in the proportions that they are weighted in the index. This was the first index tracker made, and remains one of the core index trackers that investors use, even those based in the UK.
Why would you want to buy them?
Diversification: If you own 2 companies’ shares and one of them goes bankrupt, you can instantly lose 50% of your money. Buy an index of 100 companies and one goes bankrupt, you’ve only lost 1% of your money. This gives some protection against bad things happening.
Lower risk: All investors make mistakes, beginners make even more. Buying an index fund means nobody is picking stocks (either you or an active manager), reducing this risk.
Low cost: index funds don’t have anyone making investing decisions. This makes them very cheap to run, reducing the fees to you. This compounds over the years making a huge difference to your returns.
Simple: You can concentrate on saving money and adding it to your investment account. No stressing about the news. No reading through accounts. Just buy, forget and grow.
What’s the difference between an index fund and an ETF?
A lot of people confuse these, in fact often when people say ‘index fund’ you’ll find they are actually talking about an ETF. They are essentially the same, it’s just a slightly different purchase method.
ETFs are funds bought and sold on stock exchanges like shares. The price (and therefore value) goes up and down with demand like other shares.
Index funds are a pot of money that has been invested in shares, that you can put money into the pot and it will be invested. They are usually priced once a day and you can buy into the fund at that price.
For beginners it doesn’t matter too much, they do a similar job at a similar price.
Which index funds should a beginner look at?
You can choose an index fund that covers any area that you are interested in. Most beginners in the UK look at one of these three:
- Global funds that spread your money across companies in many different countries, usually either all or all developed countries.
- UK index funds focused on the London Stock Exchange e.g. FTSE 100 and FTSE 250 mentioned above.
- US index funds that track US companies, the S&P 500 being the most famous
Which index you want to track has more of an effect than you think. The FTSE 100 is mostly global firms with global revenue, but the FTSE 250 is more UK-focused. US funds have a high tech-component, whereas the FTSE 100 has virtually none. It is worth looking up what companies make up an index before you buy its fund.
This is obviously not a recommendation, but my largest investment (other than my house) is VWRL, the Vanguard world tracker (strictly speaking an ETF).
How do index funds make you money?
Index funds will generally provide you with profits in two ways:
- Growth: if the value of the companies in the index grow in value, your investment in the fund should too.
- Dividends: when companies make profits that they don’t need to use in the company, they can pay them out to investors. Some funds (called ‘income funds’) will pay these out to the investors in the fund.
You may see something called an ‘accumulation fund’. These are funds that automatically take any dividends and use them to buy more investments, converting dividend income to growth income.
What are the risks?
Index funds are usually lower risk than putting all your money in one exciting opportunity, but that doesn’t mean that there isn’t risk.
They will fluctuate over time, so if you need the money soon (usually less than 5 years), you’ll probably prefer a more cash-like investment.
They also reflect the companies in the index, so if e.g. the US economy gets worse, it is likely that the funds based on the companies in that economy will suffer too (so the US index funds, and to a large extent the global ones too). Recessions tend to hit large proportions of the world at once, so index funds won’t prevent you from losing money during them if the index drops.
There is of course risk in all options. Keeping your money in cash has a huge risk of losing money to inflation. You can’t eliminate risk, you can only find a risk / reward relationship that you’re comfortable with.
How do I buy one?
You can buy index funds as with all shares through a broker (online platform), usually as part of a Stocks and Shares ISA to save on tax. Both funds and ETFs are usually bought the same as any other investment, as long as you know its name and/or ticker (e.g. VWRL) you can search for. I’ve got a getting started post if you want more detail.
Why I love index funds
I have virtually always kept over half of my stock investments in index funds. With a single purchase you spread your investment over tens, hundreds or even thousands of different companies all at once, giving instant diversification. They stop me getting distracted by exciting high risk shiny objects that are as likely to lose me a fortune as make me one. Most importantly though, their relative stability and historical successes let me sleep easier at night.