The beginner’s guide to index funds

What is an index fund?

An 'index' is a list. In the world of index funds, an index is simply a list of businesses or other investments. For example, the S&P 500 is a list of the 500 biggest businesses in the US.

A 'fund' is a pot of money collected from different investors, used for a specific purpose.

An 'index fund' is therefore a pot of money that invests in a specific list of businesses.

Think of them like an all-you-can-eat stock market restaurant, where you can get a taste of every dish rather than gambling on two or three courses.

If you have a pension, you likely already have some exposure to index funds. Pension providers make use of index funds and other investments in the same way that individuals can – whilst often charging you additional fees for the service.

There are a variety of index funds set up to track and invest in companies within the S&P 500. However, the S&P 500 is just one index – one list of businesses. There are literally thousands of different index funds which all focus on investing in different areas.

To keep it simple for this beginner's guide, we can say that some index funds invest in different types of businesses, for example, based on their size or location. Some focus on specific countries or continents, others are global and cover the entire world.

As an investor, your job is to decide which list(s) you want to track.

Some randomly selected examples of index funds are:

Fund name	What it does
Fidelity Index World Fund	Tracks large and mid-sized companies across developed markets like the US, Japan and Europe
iShares S&P 500 Index Fund	Tracks the 500 largest publicly traded companies in the US
iShares Core FTSE 100	Tracks the 100 largest companies by value listed on the London Stock Exchange
Vanguard FTSE 250	Tracks the 101st-350th largest companies listed on the London Stock Exchange
iShares Core MSCI Emerging Markets	Tracks large, medium and smaller companies in countries like China, India, Brazil and South Africa

Understanding index fund names

The names of funds can be confusing and a little overwhelming for most people, especially beginners.

Here's all the different types of information you might come across in a fund name, and what order you'll normally see them in:

(Fund provider) (what it invests in) (regulatory information) (share class details) (dividend treatment)

Fund provider: This is the company that manages the fund – for example, Vanguard, BlackRock, or HSBC. They’re responsible for running the fund, choosing what it invests in, and handling the admin.

What it invests in: This part tells you the fund’s focus, such as “FTSE 100 Index,” “Global Bond,” or “US Equity.” It shows what assets the fund tracks or holds, giving you a clue about its risk and performance potential.

Regulatory information: You’ll often see phrases like “UCITS” (which means the fund meets EU investment regulations) or “OEIC” (Open-Ended Investment Company). These indicate how the fund is structured and governed.

Share class details: Funds often have different share classes, shown by letters like “A” or “C”. These relate to who the fund is aimed at (e.g. individual vs institutional investors) and the fee structure they pay.

Dividend treatment: Finally, you’ll see terms like “Acc” or “Inc.” “Acc” (accumulation) means any dividends are automatically reinvested to buy more units, while “Inc” (income) means dividends are paid out to you as cash.

Sometimes you'll also see the ticker at the end of a fund name. This is the short alphanumeric code that's unique to every stock or fund.

The most important thing to know is that you can easily find out what every fund invests in by Googling its name. You should also check out our full guide on understanding index fund names.

If you're more of a visual learner, check out our index funds for beginners video course. Hosted by Damien from Damien Talks Money, it's totally free, and takes less than an hour.

Different types of index funds

Index funds come in two main flavours:

Index mutual funds

These are the more traditional option. They can be bought or sold once per day at a price set after the markets close. They’re simple, steady, and often used in workplace pensions or long-term investment accounts. They also have a higher minimum investment amount. 

Exchange-traded funds (ETFs)

ETFs do the same job – tracking an index – but they’re traded on stock exchanges just like shares. This means their prices move up and down throughout the day, and you can buy or sell them instantly via an investment platform. They tend to be much cheaper to invest in than a mutual fund – sometimes you can start with as little as £1. 

Both types are designed to give you broad, low-cost exposure to markets, but ETFs tend to offer a bit more flexibility, while traditional index funds are often used for set-it-and-forget-it investing.

Head here to learn more about the differences between traditional index funds here, or read our beginner's guide to ETFs.

Why would you use an index fund?

Index funds are the ideal way to invest without needing to second-guess the market, chase trends, or spend your Saturday night reading company balance sheets. They're ideal for cautious investors who want a hands-off approach and to let the market do the heavy lifting.

Most importantly of all, though, there's good evidence to back them up:

• Manually picking stocks underperforms tracking the market for over 90% of investors long-term
• Indexes like the S&P 500 have returned an average annual return (pre-inflation) of 10.31% since it was founded in the 1950s
• Index funds often outperform professionally-managed funds long term.

In other words, you don’t need to be a financial genius to get solid results.

Here's what the average S&P 500 return looks like in action, invested over a 32-year period:

You invest £200 per month starting on your 18th birthday and continued until your 50th birthday, whilst reinvesting dividends and achieving a 10.31% average annual return, you would have a balance of £543,266.09 despite only investing £76,800.

This is thanks to the power of long-term compounding:

The returns in our example come from playing the long game, and not cashing out even when markets took a dip.

That's something that can be tough to do without a bit of perspective.

Take a look at the chart below, which shows the annual percentage return from global markets since 1980, as measured by the MSCI World Index:

You can see at a glance that the years with positive returns far outnumber those with negative returns. But when the market does take a tumble, the losses can be sharp and unsettling.

If you sold during those turbulent times, though, you'd probably be selling at a loss, and then trying to buy back in once the market has already rebounded – effectively "locking in" your losses, and missing the sharpest part of recovery.

And our chart below demonstrates the real impact trying to time the market can have on your overall gains. It shows how an investment of $100,000 into the S&P 500 in 1994 would have ended up by 2024 – again factoring in the impact of missing this index's best days. The results are pretty sobering: 

Experts vs the index

Managed funds – also known as 'active' funds – trade stocks and look for value rather than buying and holding an entire index.

The idea is to choose investments that are expected to outperform, or by avoiding those likely to fall. In other words, you’re paying a fund manager to use their judgement, research, and timing to (hopefully) deliver better returns.

Yet, time and time again, they've failed to do just that:

• A report by The New York Times showed that none of 2,132 actively managed funds beat the market, although the time period they analysed was very short in investing terms - just five years

• Older research, using a much longer 23-year time period, suggested that global index funds outperformed actively managed funds by an average of 1% per year.

That means buying and holding all companies in the index without any thought whatsoever has outperformed the smartest brains in finance, who are paid huge salaries to analyse businesses full-time.

And many of the people running these funds don't invest a penny of their own money into them. What does that tell us?

Even legendary investor Warren Buffett recommended that most investors should invest in a low-cost S&P 500 index fund:

"The 'know-nothing' investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term results than the knowledgeable professional who is blind to even a single weakness." - Warren Buffett

Whilst there are risks – which we'll cover below – and no investment should be considered 100% safe, index funds have traditionally been one of the most reliable and successful long-term investments in the modern age.

What are the risks of index funds?

The main risk with index fund investing is pretty simple and applies to all investments: you can lose money.

All investments have risk and can increase or decrease in value. Despite being successful over a long period of time, there's no guarantee they will be successful going forward. Past performance is not an indicator of future results.

As we've seen, the long-term global market has trended upwards, but there will regularly be years of economic instability and market volatility. This means that losses are not just possible but also probable when looking at shorter periods of time – something that many people might struggle with.

Just look at all the drama that unfolded over the course of one year when we invested £10 per day:

There’s also a catch for anyone who likes to steer the ship themselves. Yes, you can pick your market – UK, US, global, emerging, take your pick – but you can’t cherry-pick the passengers. 

If Shell, British American Tobacco or Meta are in the index, they’re in your portfolio, like it or not.

This can be a sticking point for anyone who prefers to avoid certain industries, controversial companies, or just wants a bit more say over what their money supports.

What's more, index funds are highly unlikely to bag you the kind of outsized returns that come from bold stock picks and market timing. With index funds, it’s more tortoise than hare – reliable, but rarely dramatic.

Finally, the more restricted you get with an index fund, the more you're basically making a bet on markets moving in a certain direction.

For example, you might invest in a FTSE 100 fund. This would be making a bet on the UK economy as the FTSE 100 tracks the 100 biggest companies in the UK.

Or, you might invest in an Emerging Markets fund, which covers a large range of 'emerging' economies including Argentina, Hungary and the Philippines, but also larger and wealthier economies like China and India - two countries with larger economies than the UK.

The risks with choosing specific funds are:

• Your investments might decrease in value
• Your investments might be outperformed by funds in other areas
• The more specific your investments are, the more risk and variance you will see with profits and losses.

As we've already established with index funds earlier in this guide, the strategy is generally to not be specific.

If buying the whole world can be profitable, should you try to outperform the market in a way that even the smartest financial experts can rarely achieve?

Why look for the needle when you can buy the whole hay stack?

How do you start investing in index funds?

To start investing in index funds, you need to use a broker.

A broker is the company or platform you use to invest. Think of brokers like supermarkets; there are lots of supermarkets, they often sell the same products but at slightly different prices, and they sometimes sell some of their own products too. It's exactly the same with index funds.

And just like with online shopping, you can sign up using a website or app, and add your investments from the comfort of your sofa.

Find a broker

The first ever index fund for individual investors was offered via Vanguard in the 1970s, and Vanguard remain one of the most widely used brokers in the UK today.

In our opinion, Trading 212 are one of the best platforms for ease of use - especially for beginners. They're also popular because they offer free fractional shares worth up to £100 when joining via referral links like this one.

Another popular option is InvestEngine because they have no platform fees (at the time of writing) and they also offer commission-free investing into ETFs.

Other commonly-used brokers include Hargreaves Lansdown, Interactive Investor, AJ Bell and Fidelity.

Once you've selected the broker or platform you're going to use, you need to deposit money into your account and set up a direct debit to automatically deposit on an ongoing basis.

Our index fund cheat sheet is a good place to start if you're looking to compare fees or see some of the most commonly-selected funds on each provider, or you can easily weigh up different brokers using our broker comparison tool.

Simplify popular brokers & their fees

A handy (free!) sheet to compare broker options

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Choose your fund

Then, select the index fund(s) you want to invest in. This process will be slightly different on every platform - we have a guide to investing in index funds on InvestEngine you could follow, and a beginner's guide to investing with Trading 212.

After that, the best thing to do is try to forget about it!

Most people that get into index funds are doing so with the intention of investing for at least 10 years, and probably for as long as 30 or 40 years.

If you want to learn more about specific types of index funds and whether they might suit you, check out the video below:

If index funds are so good, why isn't everyone using them?

Despite their potential advantages, there are a few reasons that index fund investing isn't as popular as other forms of investment.

Firstly, basic personal finance is not universally taught in schools.

Adults leave full-time education in the UK and can go onto university, get a degree, and still have no idea what an index fund is. Financial literacy is extremely low in the average person – cynics would argue that this is by design.

If you walked the streets of a random town in the UK and asked people what an index fund was, how many do you think would know the answer?

Secondly, it's a very long-term investment. Many people are more attracted to speculative short-term investments, even if the success rates are far lower and the gamble is more risky.

Thirdly, long-term investing isn't glorified. When do you ever hear about the plucky underdog that slowly got rich over the course of 30 years? That's not very Hollywood. Instead, we glorify those that got rich at a young age, even if nine out of 10 people fail when trying the same thing.

Are index funds tax-free?

You can invest up to £20,000 per financial year into a stocks & shares ISA tax-free.

You can check out our beginner's guide to stocks & shares ISAs here, which runs through how they work, what the rules are, and how you can open one.

This is one of the most generous and tax-efficient investment opportunities in the world.

In theory, you could invest £20,000 every year for 30 years. This would mean you'd invested £600,000 in total.

If you achieved a 10% average annual return, you would have a total balance of £4,371,404. That's over £3.75m earned in capital appreciation (the money you put in, increasing in value).

As of 2024, you're now able to open and invest into as many stocks & shares ISAs as you want, as long as you remain within the £20,000 total limit.

Bottom line

Index funds offer a simple, low-cost way to invest across entire markets without needing to pick winners, watch the markets daily, or pay for expensive fund managers. They aren’t risk-free, and you won’t get rich overnight – but history suggests that patient, long-term investors have been well rewarded for taking the slow and steady approach. 

If you want a hands-off way to grow your money while minimising costs and complexity, index funds are one of the best options out there.

Just remember: all investments carry risk, past performance isn’t a guarantee, and you should always do your own research (or speak to a professional adviser) before you dive in.

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