What is an index fund?

What are index funds?

An index fund (also known as a passive fund or tracker fund) is a type of investment that tracks the performance of a particular index; an index measures the performance of a group of assets, such as stocks or bonds. For example, the Financial Times Stock Exchange 100 Index (FTSE 100) is an index of the 100 largest UK companies on the London Stock Exchange. The Standard and Poor's 500 (S&P 500) is an index tracking the stock performance of 500 of the largest companies listed in the US stock market. You’ll probably recognise many of the companies on these lists, such as Apple, Amazon, Meta, Easyjet, Rolls Royce, and United Utilities.  

When you invest in an index fund, the value of your investments will rise and fall based on the collective performance of all the companies in the index. This is why investing in index funds can be less risky than buying shares in individual companies, as your portfolio will be more diverse from the start. You can make your portfolio even more diverse by investing in index funds that track a wide variety of indexes, covering multiple industries and countries. 

Learn more: How to start investing

Advantages of index funds

• Cost-effective. Index funds give you access to a slice of dozens or even hundreds of stocks at once, usually for a much lower cost than if you were to purchase all the stocks in the index individually. 
• Lower fees. The stocks included in a particular index rarely change, resulting in lower trading costs and fees.
• Diversification. Index funds make it easier to build a diverse portfolio, often reducing the amount of risk involved.

Disadvantages of index funds

• Less flexible. As an index fund tracks a specific index, you won’t be able to remove or replace underperforming stocks from the fund.
• No guarantees. Although index funds tend to be less volatile than individual stocks, as with any type of investment there are no guarantees and you could lose money. 

When you invest in the stock market, the value of your investments can go down as well as up, and you may get back less than you put in. You can reduce the risk by investing for the long term as this gives your investments time to weather any downturns in the market. If you’ll need to access your money sooner, consider saving in a Cash ISA or standard savings account instead. 

You might also like: How to save money

Do index funds pay dividends?

Yes, if the companies tracked by an index pay dividends, the index fund will pay dividends to investors. It’s up to you whether you use the dividends as a form of income or reinvest them. Reinvesting your dividends can lead to compounding returns over time, helping you grow your portfolio quickly. To work out if an index pays dividends or reinvests your money, look for the words distributing (Dist) or accumulation (Acc). Distributing means that the index pays out dividends to investors. Accumulation means any profit you earn from your investments in that index will be reinvested into the fund by the fund manager at no extra cost. 

Some index funds prioritise dividend-paying stocks, which can often lead to a better return. The best dividend fund for you will depend on your risk tolerance and goals.

Learn more: Do I need a financial advisor?

Are mutual funds index funds?

Yes, an index fund can be a type of mutual fund, but not always. A mutual fund is a fund that pools money from lots of investors to buy a portfolio of securities designed to meet a particular goal, while an index tracks a market index, like the top 100 companies listed on the UK stock market. Mutual funds are usually actively managed, meaning a fund manager selects which stocks to buy and which to avoid. 

Learn more: Top 5 financial advisors in 2024.

What’s the difference between ETFs and index funds?

Index funds and exchange traded funds (ETFs) both let you invest your money in multiple assets such as stocks and bonds. The main difference between index funds and ETFs is the way they can be bought and sold. Index funds can only be bought for the price set at the end of the trading day. An ETF, however, can be bought and sold multiple times in one day, so the price can fluctuate throughout the day depending on market conditions. 

How to invest in index funds:

1. Compare investment platforms

If you’d like to invest in index funds, the first step is to compare investment platforms. A platform (or provider) is a place where you can invest in index funds from all over the world. When choosing an investment platform, compare the types of account they have on offer. You could invest in index funds and other investments within a general investment account, but you may need to pay tax on your profits. 

If you choose a Stocks and Shares ISA, however, you can invest in the stock market tax-free. You can place up to £20,000 a year in your Stocks and Shares ISA or choose to spread your ISA allowance across multiple ISA types, including Cash ISAs and Lifetime ISAs. 

Remember: Most investment platforms will charge a fee for certain services, such as fund management fees, account fees, and trading costs. The fees may seem small, but the costs can add up over time. It’s important to research different options to see which best fits your needs and budget.

Learn more: Best Cash ISAs in the UK.

2. Open an account

Many providers let you open an account online or by downloading their app. If you already have a Cash ISA or Stocks and Shares ISA, you may be able to transfer your savings or investments to a new ISA provider. Not all ISA providers will allow transfers in, but they can’t stop you from transferring out. So if transferring an existing ISA is important to you, make sure you choose a provider that welcomes transfers. 

Always ask your new provider to transfer your funds!

If you withdraw your savings from one ISA, then deposit them into a new ISA with a different provider yourself, there is a chance HMRC will think you’ve deposited different funds. This could mean HMRC will think you’ve reached your ISA allowance when actually you’ve just deposited the same money twice. To avoid this, always ask your new ISA provider to transfer your funds for you.

3. Buy your funds

Once your account is set up, you can make your first deposit and start investing! It’s up to you whether you invest a lump sum straight away, make smaller investments on a regular basis or both. Many providers will let you set up a weekly or monthly direct debit so that you can grow your portfolio without having to think about it. 

Good to know

The sooner you start investing, the more opportunities your money has to grow. For example, a £5,000 lump sum invested today could grow to £8,235 over a 10-year period (if we assume an annualised return rate of 5%), even if you make no further contributions. However, investing your money gradually can have benefits too. Making regular contributions is known as ‘cost averaging’. It can help you reduce risk, make investing part of your routine, and avoid making investment decisions based on emotion.