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.

There are many variations between funds with differences that range from subtle to extreme – we’ll cover all of that in a more advanced lesson.

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

Three randomly selected examples of index funds are:

• Fidelity Index World Fund P
• iShares S&P 500 Index Fund
• Vanguard FTSE Global All Cap

The names of funds can be confusing and a little overwhelming for most people, especially beginners. The important thing to know is that you can easily find out what every fund invests in by Googling its name.

The three funds in our example are managed by different fund providers (Fidelity, BlackRock which manages iShares, and Vanguard). They also invest in slightly different things; the Fidelity fund invests in ‘global developed markets’, the iShares fund invests in the biggest businesses in the US, and the Vanguard fund invests across the entire world.

This guide isn’t here to help you decide which fund is best for you – nor is it here to convince you to invest in the first place.

Why would you use an index fund?

Before we get to the risks, the three main reasons you’d use an index fund are:

• Manually picking stocks underperforms 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.

If you invested £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 £603,672.69 despite only investing £76,800.

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

Whilst lots of people think they are capable of beating the stock market, index funds typically outperform managed funds run by professional money managers. Managed funds are also known as ‘active’ funds because they actively trade stocks and look for value rather than buying and holding an entire index.

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 5 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.

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 that we’ll cover below, and no investment should ever be considered safe, index funds have traditionally been one of the safest and most successful long-term investments in the modern age.

The first global index fund was founded in 1976. If you pick any day from when the first index fund was founded until today, you would have a 94% chance of making a profit if you invested for 10 years or more. This percentage grows further as time goes on, and decreases based on smaller time periods (73% chance of making a profit if you invest for 1 year, 66% if you invest for 3 months, 52% if you invest for 1 day).

What are the risks?

The main risk with index fund investing is pretty simple: 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.

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.

There are other risks with index funds that still relate to losing money, either directly (making a loss) or relatively (being outperformed by other investments):

• Your fund won’t perfectly track the index: the goal is to track it as closely as possible, but it will never be perfect.
• If the market crashes, you’re not flexible to move into other assets.
• No ‘stop-loss’ option: you won’t automatically be cashed out on a sudden drop or crash in price.*

*Counter point: this is basically the whole point of long-term index fund investing: to continue buying and holding regardless of where the market is on any given day. The logic is that ‘time in the market’ is a lot better than ‘timing the market’.

If you don’t invest in a global fund, or an S&P 500 fund, you’re making bets on other things happening.

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? Many people would argue that to do so would be speculating or gambling, rather than investing.

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

How do you start?

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.

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

In my opinion, Trading 212 are one of the best platforms for ease of use – especially for beginners. They’re also popular because they offer a free share worth up to £100 when joining via certain links like this one.

Another popular option is InvestEngine because they have no platform fees (at the time of writing) and they also offer up to £50 in free cash when you deposit at least £100 via our link.

It’s worth noting that other platforms have also offered no platform fees in the past but have tended to introduce small fees further down the road.

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

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.

And please remember: this content does not represent financial advice; we are not financial advisors. When investing, your capital is at risk. Investments can rise and fall and you may get back less than you invested. Past performance is no guarantee of future results.

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.

Then, select the index fund(s) you wish 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.

After that, the best thing to do is try to forget about it! Short-term fluctuations are to be expected, and ‘short-term’ in the world of index funds really means anything under a 10-year period.

This chart from MacroTrends shows how every year of the S&P 500 has significant ups and downs, despite the long-term average return of around 10% per year:

If you started investing in S&P’s index in 1928, 4 of the first 5 years would have produced losses!

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.

Compounding is an amazingly powerful thing as we showed in the earlier example, but it usually takes 20+ years to really work its magic. If you invested £200 every month for 35 years and achieved an average annual return of 10%, you would earn more in year 35 (£72,468) than you would in the first 17 years combined (£66,540).

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 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 9 out of 10 people fail when trying the same thing.

Despite all of the above, index funds are rising in popularity. Here’s how demand for ‘index funds’ searches has increased since 2004 in the UK, according to Google Trends data:

Are index funds tax free?

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

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). And it’s tax-free.

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.

All investments have risk. You can lose money when investing. This is not financial advice.

Using an auto-enrolled work-based pension?

The fund you're contributing to might not be right for you

Send The Info