Index funds, also known as tracker funds, are a type of mutual fund that tracks the performance of a given index, providing investors with exposure to a range of different assets in one cost-effective package.
In the UK, there are several exchange-traded funds and mutual funds that provide investors with access to broad stock market indices, such as the FTSE 100 or S&P 500. If you're wondering how to invest in index funds in the UK, read on for a comprehensive guide.
Index Funds Explained
Index funds are a type of mutual fund or exchange-traded fund (ETF) that track the performance of a given index. An index is an aggregation of stocks, bonds or other securities that together represent a specific market or sector.
These are managed by professional fund managers who decide which stocks or bonds to include. Once the index has been established, it is passively managed according to its specifications – no active trading decisions are made, meaning that all investors receive an identical return from their investment.
Top Platform to Invest in Index Funds
What Are the Benefits of Investing in an Index Fund?
Now that you know what index funds are, let's look at some of the key benefits that they offer.
Diversification
By investing in an index fund, investors get benefits from instant diversification across a range of stocks or bonds. This reduces their risk by spreading it over a larger number of investments and helps to even out returns over time. Most index funds comprise up to several hundred stocks or bonds, meaning that they are highly diversified and present minimal risk to the investor.
Market Exposure
Index funds provide investors with access to a range of different assets from around the world. This means that investors can gain exposure to a wide variety of investments without having to buy individual stocks directly.
For instance, the Dow Jones comprises 30 of the largest US companies and UK investors can gain exposure to this through an index fund.
Low-Cost
Index funds are generally cheaper than individual stocks as they lack the costs associated with active management. This makes them a cost-effective way for investors to gain exposure to a broad range of investments without spending much.
Index funds are generally seen as being one of the best investments for beginners due to their low cost and diversification benefits. They can also be a great starting point for those who don’t have the time or knowledge to research individual stocks.
In addition, index funds are often seen as a more passive form of investment than actively managed mutual funds. This makes them ideal for novice investors who don’t have the time to follow stock market movements closely.
Index Funds vs Actively Managed Funds: How Are They Different?
An index fund and an actively managed fund are both considered “the types” of mutual funds that provide investors with exposure to a range of investments. However, there are some key differences between the two that are worth noticing.
Index Funds
These funds are passively managed and track the performance of a given index.
- Track a given index such as the FTSE 100
- Passively managed according to the specified rules of the index
- Lower cost than actively managed funds
- Instant diversification across a range of stocks or bonds
- Returns may not beat the market
- Lack of individual stock selection means there is limited scope for outperforming
Actively Managed Funds
An active fund is managed by a professional fund manager, who will make decisions on which stocks to buy and sell. They're sometimes called mutual funds.
- Potentially higher returns than index funds
- Active management allows for greater flexibility in stock selection
- Professional fund manager with extensive knowledge
- Higher cost than index funds due to active management fees
- The performance of the fund may not match that of the entire market
- Risk of underperforming if fund manager’s decisions are not profitable
- Potentially greater risk than investing in an index fund as individual stock selection carries more risk.
How to Invest in Index Funds in the UK
So far, we’ve looked at the fundamentals of index funds, how they work, and how they differ from actively managed funds. Let’s now look at a step-by-step guide to help you get started investing in index funds.
Choose a Trading Platform
The first step is to choose a trading platform that offers index funds and sign up for an investment account. There are many online trading platforms available such as Hargreaves Lansdown, AJ Bell, and eToro offering different features. Here are some factors to consider before making your choice:
Cost and fees: Trading costs typically include account fees, shareholder fees, trading fees, and other fund-related charges. Get the best deal after comparing the fees across different investment platforms.
Account features: Each platform has different features such as tax efficiency, auto reinvestment of dividends, and many more. Choose the platform as per your requirements.
Index funds available: Check if the platform offers access to the index funds you are interested in investing in. Note that you may have different funds tracking the same index so consider each option before making your decision.
Regulatory compliance: Ensure that the platform is regulated by a recognised financial body such as the Financial Conduct Authority (FCA) in the UK. This ensures that your money is protected in case of any major problems with the platform.
Choose Which Index Fund You Want to Invest In
Once you’ve chosen a trading platform, it’s time to decide which stock market index fund you want to invest in. Consider factors like returns, costs, and risks associated with each fund before deciding which one to go with.
Also, check if there are any restrictions such as a minimum investment amount or a holding period for the fund.
Deposit Funds
Once you’ve chosen your index fund, you can deposit funds into your trading account to purchase units. The amount you are able to deposit will depend on the rules of the platform and the index fund, so make sure to check this before investing any money.
However, if you're not sure how much to invest, here are 3 factors to consider before putting in your hard-earned money:
Your Financial Goals: Consider your financial goals and the amount of time you want to achieve them. For example, if the fund you're investing in brings you an average of 8% profit a year and your goal is to double your money in 5 years, then you'll need to invest an amount that will allow you to do so.
Your Risk Tolerance: Consider how much risk you're comfortable with taking on, as this will determine the type of investments you should make. For example, if you're not comfortable with taking on too much risk, you may want to go with a more conservative index fund such as one that tracks the FTSE 100.
Your Available Funds: Consider how much money you are able to invest. It's important not to overextend yourself and make sure that you have enough funds for other investments or day-to-day living expenses.
Place Your Trade
The last step is to place your trade. You can do this by buying a fund directly or investing via an ISA (Individual Savings Account) or a SIPP (Self-Invested Personal Pension).
An ISA is a tax-efficient way to save and invest and you don’t have to pay any capital gains tax on profits made from investments. A SIPP allows you to save for retirement by investing in stocks, shares, and other assets. Both account types can offer investment options that invest in index funds so you may consider them if you're looking to save or invest for the long-term.
Unlocking Earnings With Index Funds
Once you’ve bought the index fund, there are several ways to earn money with it. You may be able to gain profits if the market price of the stocks in the index rises and falls due to factors such as company performance, government policies, or industry trends.
The net asset value (NAV) is the sum total of all the assets in an index, exempting all its liabilities. It's also known as the intrinsic value of an index fund and provides investors with a snapshot of how much their investments are worth at any given time.
Think of NAV as a yardstick for measuring an index fund's performance. The higher the NAV, the better it is. As such, looking at the NAV of a fund can give you a good indication of the potential returns that you could get over time.
Dividends
Dividends are payments made to shareholders or unit holders of the index fund. They are typically paid in accordance with the company's profits, meaning that if a company does well, then it can pay out more money to its investors.
The good news is that some index funds pay out dividends. This means that you will receive a portion of the fund’s profits as a cash payment on a regular basis, typically once or twice a year.
The amount you receive depends on how many units you have purchased – so the more units you own, the more money you can make from dividends.
For example, if an index fund pays a dividend of £0.03 per unit and you own 10,000 units, then you will receive a total dividend payment of £300 (10,000 units * 0.03).
Capital Gains
You may also be able to make money from capital gains when investing in index funds. This occurs when the value of the fund increases due to a rise in the NAV or market price of the stocks it is tracking.
For example, if you purchase 1,000 units of an index fund that has a NAV of £50 and then later on its NAV rises to £60 per unit, then your capital gains will be £1,000 (1,000 units * £10).
Common Charges of Investing in Index Funds
When investing in index funds, there are several fees that you should be aware of. These include:
Shareholder Fees: This is the fee charged by a broker or financial institution for providing access to the fund and managing your investments.
Account Fees: This is an administrative fee charged by a brokerage firm to maintain your account. It usually applies when opening and closing accounts, transferring money, or trading.
Redemption Fees: Some brokers may charge a redemption fee if you decide to sell your units in the fund before reaching the holding time period (generally one year).
Annual Fund Operating Expenses: Funds incur operating costs for things such as management salaries, legal fees, and other administrative costs. The amount varies depending on the fund and it is paid out of the fund’s assets before dividends or capital gains are paid out.
How Do I Choose an Index Fund?
Once you have a better understanding of how index funds work, it’s time to start researching different funds and finding the one that best meets your needs. Here are some key metrics to consider when choosing an index fund:
Performance: Look for a track record of consistent returns over time. It might be difficult for a fund to stay profitable every quarter, but it’s important to look for a solid track record of positive performance over a longer period.
Fees: Compare the fees of different funds to make sure you’re not paying too much for the privilege of investing in a particular fund.
Investment Objectives: Determine what you’re trying to achieve with your investments and invest accordingly. For example, if you’re looking for income then focus on funds that pay dividends and if you’re looking for capital growth then look for funds that track an index with stocks that have potential for growth.
Risk: Consider the level of risk associated with each fund because some funds are more volatile than others. If you’re a conservative investor then it’s important to choose a fund that is less risky.
When you’re researching index funds, it’s important to look at reputable sources of information. Look into news or educational websites to get a better understanding of how index funds work and how they performed in the past.
You may also consult with a financial advisor who can give you tailored advice about which fund would be best for you.
Best Index Funds to Invest Now
Now that you have a better understanding of index funds, here are three of the best-performing funds for UK investors:
5-year performance | Management fee | Fund size | How to Invest | |
|---|---|---|---|---|
iShares Core FTSE 100 ETF | 3.59% | 0.07% | £11.14 B | |
Vanguard FTSE 250 UCTIS ETF | 0.38% | 0.1% | £1.8 B | |
Vanguard FTSE Global All Cap Index Fund | 50.7% | 0.23% | £2.35 B |
