What is an index fund?
An index fund is a type of investment fund that follows a specific market index, such as the FTSE 100, and aims to match its performance. Also known as an index tracker or tracker fund, index funds are usually either a unit trust, OEIC or exchange traded funds (ETFs).
Buying into an index fund sees your money pooled with that of other investors, allowing you to invest in a wider range of assets than if you were buying them individually.
Keep in mind that the value of your investment can go down as well as up, so you could get back less than you invested.
How do index funds work?
When you invest in an index fund, your money, and that of the other investors, is used to buy the assets that make up the fund. You won't own any of the individual assets yourself, nor will any of the investors, but you will own a share of the fund's overall value. This share of the value will correspond to the amount you have invested.
Index funds are passive funds
Most index funds are passive funds. This means they aren't actively managed by a fund manager, so the aim isn't to outperform the market index. Instead, a passive fund will be designed to match the index it's tracking.
The fund does this by replicating the index's asset allocation. For example:
An index fund is tracking the FTSE 100. It will buy shares in all the companies making up the share index. The proportion of shares the fund buys for each company is equal to the company's weighting within the index.
The weighting is a percentage based on the company's market capitalisation (market cap). This is calculated by multiplying a company's share price by the amount of shares it has issued. The higher the market cap compared to the other companies in the index, the greater the weighting.
The greater a company's weighting, the more impact it has on an index's performance.
By replicating the share index in this way, the fund should, in theory, replicate its performance.
Not all index funds behave in this way. Some, particularly those tracking very large or global indexes, will buy a representative sample of shares to keep costs down. The aim still being to closely match the index's performance.
What is a market index?
A market index, also known as a share index or stock market index, groups together a set of assets to represent a segment of the financial market. The FTSE 100, the FTSE All Share, and the S&P 500 are three such indexes.
Market indexes are used as benchmarks for actively managed funds. When the fund is set up, the fund manager will choose an index to benchmark against and aim to beat it.
For example, an equity fund is using the FTSE 100 as its benchmark and that index returns 6% in a year. If the equity fund returns 8% in the year (or anything above 6%), it has outperformed its benchmark.
In contrast, an index fund isn't actively managed, so its aim is to match the performance of the index it tracks. Using the previous example, it would be aiming for a 6% return.
How do you get a return from an index fund?
There are two ways in which you can potentially get a return from an index fund:
- Capital growth – Capital growth occurs when the value of the assets held within the fund increases. This increases the fund's net asset value (NAV), which is the total value of the fund's assets minus its liabilities and expenses. A return is made when you sell your share of the fund and the NAV is higher than when you first invested. This is known as a capital gain.
- Dividends – Some index funds provide an income via dividends. These are payments some companies make to their shareholders out of their profits. If the fund holds shares in companies that offer a dividend, these will be paid to you. The amount you are paid will correspond to value of your share in the fund. Index funds usually offer the option of 'income' or 'accumulation' when you first invest. An 'income' fund will pay the dividends to you in cash, at regular intervals. An 'accumulation' fund will reinvest the dividends, increasing your share in the fund.
What types of index fund are there?
There are thousands of widely recognised market indexes globally. These represent every type of investment, asset, sector, sub-sector, region and segment imaginable.
Index trackers that follow these indexes tend to be held in the following types of investments:
- Unit trusts – When you invest in a unit trust, your money buys units in the fund. These units represent the index fund's underlying assets. The number of units you receive depends on the amount you invest and the unit price at the time. The unit price is based on the fund's net asset value (NAV). A unit trust is classed as an open-ended fund, meaning new units are created or cancelled as investors buy or sell.
- OEICs – OEIC means open-ended investment company. Like a unit trust, it's also an open-ended fund. There are subtle differences between an index tracker that's a unit trust and one that's an OEIC. The first and most evident is that a unit trust is a trust, which is governed by trust law, while an OEIC is a company, governed by company law. Secondly, with an OEIC you are buying shares in the fund, not units. And finally, OEICs usually have a single price for buying and selling at, whereas a unit trust tends to have a price for each.
- ETFs – ETFs are exchange traded funds and mainly index trackers. They are listed on the stock exchange and their prices change throughout the day like any other traded asset. Apart from this, they follow the same principles as any other index fund.
What are the pros and cons of investing in index funds?
These are a few of the advantages and disadvantages of investing in an index fund:
| Advantages | Disadvantages |
|---|---|
| Risk is spread by exposure to a range of different companies within the index being tracked | If market volatility affects the index being tracked, the value of your share in the fund can fall |
| You don't have to choose or research individual assets, as the fund mirrors an index | You must accept what makes up the index, good or bad |
| There's no active management, so fees and costs are usually lower | Lack of active management means the fund doesn't have the opportunity to outperform the market |
| Changes in the index are generally reflected by the fund (minus fees) | Funds tracking indexes that are dominated by a single sector or a few large companies are vulnerable to their performance |
Overall, index funds can help to build a diversified investment portfolio, along with other types of investment. Investing in different types, asset classes, business sectors, and geographical regions, helps to balance your portfolio, spreading the risk so your potential returns aren't reliant on the performance of a single investment.