What are index funds?

What are index funds?

An index fund is an investment that mirrors the performance of a specific market index by holding the same stocks or bonds in the same proportions as that index. For example, a FTSE 100 index fund owns shares in all 100 companies listed on the FTSE 100 index, weighted by their market value.

Instead of trying to beat the market through active stock picking, index funds simply match the market's performance. This passive approach means much lower costs and consistent returns that mirror the broader market.

How index funds work

When you invest £1,000 into a FTSE 100 index fund, your money is pooled with thousands of other investors to buy shares in all 100 companies. If the FTSE 100 rises by 5%, your investment should also increase by approximately 5% (minus any fees).

Why invest in index funds?

Like all investments, index funds come with their own set of advantages and drawbacks.

Pros of index funds

• Diversification — rather than needing to research and buy individual stocks, one index fund gives you exposure to hundreds or thousands of companies across different sectors. This spreads your risk significantly

• Low costs — index funds typically charge annual expense fees of between just 0.1% and 0.7%, compared to as much as 2% or more for actively managed funds. Over time, these lower fees can save you thousands of pounds in investment returns

• Simplicity — there’s no need to research fund managers or investment strategies. Index funds automatically rebalance to match their target index

• Tax efficiency — index funds generate fewer taxable events than actively managed funds, as they trade less frequently

• Consistent performance — while for obvious reasons, you won't beat the market, you also won't significantly underperform it either. Many analysts argue that most actively managed funds fail to beat their benchmark index over 10+ years

Cons of index funds

• Market risk — index funds will fall when markets fall. There's no active management to potentially limit your downside during market crashes

• No outperformance potential — you'll never beat the market with index funds, you'll only match it (minus fees)

• Limited control — you can't exclude companies you don't want to invest in, or go overweight on sectors you prefer

Types of index funds available

By asset class

• Stock index funds — track equity indices like the FTSE 100 or S&P 500
• Bond index funds — track bond indices like UK government bonds
• Balanced funds — combine both stocks and bonds in one fund

By geography

• UK index funds — track UK market indices (FTSE 100, FTSE All-Share)
• US index funds — track American indices (S&P 500, NASDAQ)
• Global index funds — track worldwide stock markets
• Emerging markets — focus on developing economies

By company size

• Large cap funds — track the biggest companies (FTSE 100)
• Small cap funds — track smaller, growing companies
• All cap funds — include companies of all sizes

By investment vehicle

• Exchange Traded Funds (ETFs) — trade on stock exchanges like individual shares. You can buy and sell during market hours at live market prices. Most index funds today are constituted as ETFs due to their flexibility and low costs
• Investment trusts — closed-end funds that trade on stock exchanges. May trade at a premium or discount to their underlying net asset value
• Unit trusts/OEIC funds — open-ended funds bought directly from the fund company. Priced once daily after markets close
• Real estate investment trusts (REITs) — specialise in property investments, offering exposure to real estate markets

How to start investing in index funds

Step 1: Choose your investment account

You'll need one of either:

• Share dealing account — for buying individual ETFs and investment trusts
• Stocks & Shares ISA — tax free wrapper for up to £20,000 in investments annually
• IG Smart Portfolio — our professionally managed portfolio of ETFs, adjusted to your risk appetite

Step 2: Decide your investment strategy

Key considerations include:

• How much to invest — start with what you can afford to lose as you build confidence
• Investment timeline — index funds work best for 5+ year investments
• Risk tolerance — younger investors with longer time horizons can typically take more risk
• Geographic split — UK vs international exposure

Step 3: Select your index funds

Popular beginner options include:

• Vanguard FTSE All-World — global stock market exposure in one fund
• Vanguard FTSE Developed World UCITS ETF — developed markets only
• iShares Core FTSE 100 — UK's largest 100 companies by market capitalisation
• Vanguard S&P 500 — America's largest 500 companies by market capitalisation

Step 4: Make your purchase

1. Create or log into your IG account online or through our IG Invest App.
2. Search for your chosen index fund.
3. Decide how much to invest.
4. Place your buy order.
5. Set up regular monthly investments if desired.

Step 5: Monitor and rebalance

• Review your investments quarterly, not daily
  Consider rebalancing on a quarterly basis if you hold multiple or volatile funds
• Stay invested through market ups and downs

Popular index fund examples

Popular index funds to consider include:

• Vanguard FTSE 100 UCITS ETF
• Invesco QQQ Trust
• iShares Core MSCI EAFE ETF
• SPDR Dow Jones REIT ETF
• WisdomTree Brent Crude Oil ETC
• Invesco Physical Gold ETC
• WisdomTree Wheat ETC
• BlackRock Income & Growth Investment Trust

Getting started today

Index fund investing doesn't have to be complicated. For most beginners, a simple portfolio split might include:

• 60% global equity index fund (like Vanguard FTSE All-World)
• 40% bond index fund (like Vanguard Global Bond Index)

As you become more comfortable, you can adjust these allocations based on your age, risk tolerance and investment goals.

The most important thing is to start investing regularly and stay invested for the long term. Time in the market typically beats timing the market.

But remember, despite the lower risk profile of index funds, all investments carry some risk and past performance is not a guarantee of future results. Consider seeking independent financial advice before making investment decisions.