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What is an index fund?

If you’re looking for an easy way to begin investing or diversify your existing portfolio, index funds can be a great choice. But what is an index fund, and how does it work? We’ll take a closer look below.

Index funds explained

Every day, indexes track the movements of markets around the globe. They may focus on a select group, like the Dow Jones Industrial Average, or look at a wider range of stocks like the S&P 500. Rather than focusing on individual shares, an index fund tracks the performance of this entire market index.

When you buy shares in an index fund, you’re investing in all of its components to maximise value and minimise risk. Fund managers act as an intermediary to make sure the index fund accurately tracks and keeps pace with the index in question. The benefits include exposure to a broad market and lower operating expenses than other types of funds. No matter what the market’s doing, the funds simply follow the benchmark index.

ETF vs index fund

An ETF, or exchange traded fund, is a collection of stocks that can be bought and sold throughout the day just as a stock would. When looking at an ETF vs index fund, one of the primary differences is that index funds follow their benchmark index, while an ETF fund manager tries to beat the benchmark. Another difference is that you can only buy or sell an index fund at the end of the trading day.

Index fund vs mutual fund

A third type of fund to look into is a mutual fund, which is also a collection of stocks. Like index funds, these can only be bought or sold at the conclusion of the trading day. However, there are also a few differences when comparing an index fund vs mutual fund. Like ETFs, they are often actively traded. This means that the fund manager actively chooses which stocks will go into the fund, rather than automatically including the full index.

How to invest in index funds

If you’re thinking about investing in index funds, there are a few key steps.

Step 1: Choose the index.

There are hundreds of indexes to choose from, some being region or industry-specific and others being more widespread. If you really want to diversify your investments, look for a global index fund like the FTSE Global All Cap Index composed of company shares from markets around the world. Because a global index fund includes shares from large, small, and entry-level companies in emerging and established markets, it covers all your bases. 

Step 2: Choose the fund.

The next step is to find a fund that tracks your index of choice. For particularly popular or well-known indexes like the London Stock Exchange’s FTSE 100, you’ll have dozens of funds to choose from. Look at the average index fund return along with any associated restrictions and fees. You should also consider your risk tolerance.

Step 3: Purchase shares in the index fund.

To purchase shares in the index fund, open an account directly with the mutual fund company. Another option is to find a broker specialising in index funds and open a brokerage account. To make the best decision, compare costs, features, and perks. Brokers often charge more, but if you plan to make multiple investments it’s often easier to open a single brokerage account.

Advantages of index funds

There are multiple benefits of index funds:

  • High average index fund return – Generally, index funds outperform actively managed funds over the long term.

  • Diversification – Investing in funds offers an easy way to diversify your portfolio in comparison to purchasing individual stocks and bonds.

  • Transparency – Most index funds track exactly what’s in the index, so you can see where you stand at any time.

  • Low trading costs – With passive management, operating costs are reduced. There’s no need to pay for portfolio managers as the portfolio contents rarely change.

Disadvantages of index funds

While the benefits are manifold, index funds aren’t right for everyone. Here are a few disadvantages to consider at the same time.

  • Rigidity – This is one of the least flexible ways to invest, because the fund never strays from the index in question. Managers hold no sway and can’t remove underperforming stocks.

  • Lower returns – Index funds rarely outperform the index in question. While ETFs and mutual funds aim to post higher returns than the benchmark, an index fund merely tracks it.

The bottom line

Index funds can be the ideal option for someone who wants a lower risk way to invest in the stock market. With a multitude of indexes to choose from, you’re likely to find one that aligns with your investment strategies. Yet it’s important, as with any investment, to do your research first.

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