Welcome to the Index Fund Beginners Guide.
What is an Index Fund?
An index fund is a collection of companies or assets which can be bought like a single stock.
An index fund mirrors the performance of a particular index by investing in all the holdings in that index. You can then buy the Index Fund so to you don’t have to buy all holdings individually.
For example, the FTSE 100 Index contains the biggest 100 companies listed on the London Stock Exchange. If you buy a FTSE 100 Index Fund you will own a share of each of one of those companies (1).
What are the different types?
The very first index fund set up Jack Bogle of Vanguard tracked the S&P500. Today there are indices that track all the major markets across the world.
There are also index funds with track particular sectors, fixed income and commodities markets.
The advantages of investing in Index Funds
Low cost – index funds are a very cost-effective way of investing. The fund manager does not have to spend a lot of time choosing the stocks, so the charges are generally much lower than other forms of investment vehicles like mutual funds. Fees can start from as little as 0.06%.
Saves time – you don’t have to spend time picking and managing a portfolio of individual shares.
Simple diversification – by owning all the companies in an index you own companies in different industries and sectors of the economy. If one industry or company does badly it will only have a small impact on your overall portfolio compared to an investment strategy of owning just a few companies where if one goes wrong it can have big impact on your portfolio.
Transparent – it can be confusing trying to work out which investments and costs are involved in some investment funds. Index Funds have no performance fees or hidden trading costs. All costs and holdings are made easily visible in the fact sheet which accompanies each fund.
Wide choice of different investments – you can buy stock or bonds indexes from countries and regions across the globe.
Passively Managed – index funds are passively managed which means there is little human intervention as a manager simply buys all the stocks in the index. This takes out the human error of trying to time the market or trying to predict which individual companies are going to perform best.
Good track record – they have a particularly good track record compared to actively managed funds which pick individual stocks. Only 25% of actively managed funds outperformed the Index in Europe over the last five years. (2)
The disadvantages of investing in Index Funds
Low cost not no cost – while some index funds are unbelievably cheap some more specialist index can be more expensive. Take Vanguard the cheapest operator in the market. The prices can range from 0.06% for FTSE 100 Index Unit Trust to 0.6% Vanguard Emerging Markets Bond Fund (3). You will still have to pay any management fees your broker charges for holding your investments.
How much you spend on your investments costs is one of the most important things to bear in mind when you are investing.
Diversified but not risk free – index funds are still subject to any overall market risk or economic decline. When the Covid-19 Epidemic struck the FTSE100 dropped from a high of 7674 on 11th January to a low of 5190 on 14th March just two months later. (4)
Liquidity – index funds only trade once a day so you cannot trade them during market hours like individual stocks. In the case of an emergency, you will have to wait till the price at the end of the day. This should not be an issue for long term investors. If this is important you should consider ETFs which are more liquid.
No control over the investments – when you invest in an index fund you will be invested in all the holdings in that index. You will be invested in both the weakest as well as the strongest stocks. If you don’t like some companies or some are performing badly you will not be able to remove them from your portfolio.
No guarantee of success – you will only benefit if the economy and stock market continue to grow.
Only get the market return – you will never be able to beat the market index. 63% of European active fund managers beat the market over a single year in 2020. (5)
Index Fund Beginners Guide Summary
Are Index Funds a good investment? If you don’t have the time or the knowledge to pick individual stocks, index funds are an excellent way to start investing. They have a good long term track record and low investment costs.
You can learn more about how to invest in index funds here.
Some of the world’s greatest investors recommend index funds. Warren Buffet plans to leave some of the money in his will in index funds.
‘My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.’ (6)
While they have outperformed active money managers over time there is no guarantee of future success. Investing is risky. Make sure you are comfortable with the risk involved.
For more information on Index Fund Investing read – The Little Book of Common Sense Investing
- Companies in an Index are weighted by their market capitalisation. The biggest companies make up a higher percentage of the index than smaller companies. For example, Unilever is currently (04-02-2021) the biggest company in the FTSE100 making up 6.26% of the Index. Investing £100 in a FTSE100 Index Fund would mean £6.26 would be invested in Unilever.
- Data Tracking S&P Europe 350 from 2016-2020 https://www.spglobal.com/spdji/en/spiva/#/reports
- Vanguard costs https://www.vanguardinvestor.co.uk/content/documents/legal/vanguard-full-fund-costs-and-charges.pdf
- Data taken from London Stock Exchange https://www.londonstockexchange.com/indices/ftse-100
- Data Tracking S&P Europe 350 from 2020 https://www.spglobal.com/spdji/en/spiva/#/reports
- Buffett 2013 letter p20 https://www.berkshirehathaway.com/letters/2013ltr.pdf