The best low cost index funds to buy now

Index funds (also known as passive funds or trackers) are low-cost, easy ways for investors to invest in a sector or asset class. 

These investments simply aim to replicate the performance of a certain index, such as the S&P 500 or the FTSE 100, as opposed to actively managed funds, which are run by managers who try to pick and choose stocks in order to beat an underlying index. 

The history of low cost index funds

The first index fund that was available to ordinary investors was the First Index Investment Trust, which launched at the very end of 1975 (it’s still going, but now it’s called the Vanguard 500 Index Fund). 

Almost four decades later, assets in passive tracker funds now exceed assets in actively managed funds. At the end of 2021 passive funds accounted for 16% of US stockmarket capitalisation compared to 14% for active funds, according to the Investment Company Institute, an industry body. 

Over the years investors have flocked to passive trackers as expensive active funds have proven themselves to be poor value for money. High management fees have eaten away at returns, and most managers have failed to outperform their benchmarks, leading many investors to question why they’re paying for underperformance. 

There are also signs that the actively managed exchange-traded funds (ETFs) are faring better than actively managed mutual funds. 

Investors pulled out $640bn from actively managed mutual funds in the first half of the year, reports the Financial Times, a stark contrast from the $943bn of inflows that were recorded in 2021. 

And at the same time, demand for active ETFs has been faring better “with global flows into passive mutual funds and ETFs in H1, at $431bn, less than a third of 2021’s full-year tally,” says the FT. 

A blend of active and passive

Chris Gooch, head of ETF and index sales, EMEA, at Citi notes that active ETFs have played a huge role in that move. “There has been a general trend away from mutual funds towards equity ETFs more broadly, and active ETFs have very much participated in that move”. 

The relatively smaller ETF industry attracted a net $51.8bn in the same period, the FT adds. 

Other market watchers attribute the stronger performance in active ETFs to a change in an ETF rule. The ETF rule was introduced in 2019 by the US regulator, the Securities and Exchange Commission and was introduced to make the market more competitive and make the process of bringing ETFs to the market more efficient. 

Another factor that played a part was the US regulator approved non-transparent and semi-transparent structures. 

The change meant active managers no longer had to disclose or report the fund’s daily composition, meaning some active managers could retain their “secret sauce”.  

However, passive funds are still largely the favourite go-to investment of robo-advisers. These investment platforms use a portfolio of funds to meet investors’ goals while trying to keep costs as low as possible. 

That said, while passive low cost index funds do have some attractive qualities, the nature of these products mean they cannot outperform the wider market. They’re only designed to track the market, and therefore, cannot outperform it.

Critics of passive funds also say that they lack flexibility. Even if index fund managers note a deterioration in the performance of the benchmark, they usually cannot simply trim the number of shares they own. 

There are usually fewer moonshot opportunities under passive funds. This is because in mirroring the market, there is likely to be fewer opportunities to earn a significant windfall. 

While there are usually fewer risks involved with passive investing, reward is also more limited compared to active funds. As such, some investors prefer to take their chances with active managers and are ready to weather market volatility (not all active managers have underperformed the market over the long term). 

How to look for low cost index funds

So what should you look out for when choosing the best index funds and ETFs? There are several factors to be aware of. 

Tracking error

Low costs are key, of course. But it’s also important to consider the tracking error (the difference between the performance of the index and the fund). Since the goal of the tracker is to match the performance, significant outperformance is just as much of a reason to worry as is significant underperformance, as it suggests problems with the way the fund is run. It can also indicate how fees will hit performance in the long run. 

Costs

Every penny you pay in management fees is a penny that doesn’t compound over time. So investors should look for low cost index funds with the lowest possible total expense ratios (TERs) – the annual running costs for the fund. Some brokers, such as Hargreaves Lansdown, offer management fee discounts for investors who pick their preferred funds.

Listed or unlisted

Tracker funds typically come in one of two main types: open-ended funds (Oeics), which aren’t traded on the stockmarket, or exchange-traded funds (ETFs), which are. 

Different types of funds are suitable for different types of investors. Many online stockbrokers have different charging structures for different funds. So the best fund for you might depend on which is the cheapest and easiest to buy and sell. ETFs can be bought and sold when the market is open, while Oeics can take days to buy and sell as they need to create and redeem shares for investors. 

Entry or exit fees

Some funds can charge large entry or exit fees. None of the funds on the list below charge entry fees, but there are some on the market that charge as much as 5% for new investors. 

These fees can be a huge drag on returns in the long run, especially when other charges are added. This excludes trading commissions, which some brokers might charge when dealing funds (these fees can turn even the best-looking low cost index funds into expensive investments).

Here’s a selection (it’s far from an exhaustive list) of the cheapest passive tracker funds (Oeics and ETFs) on the market right now.  

This list does not reflect all the fees and charges (as well as discounts) that might apply though different brokers. 

These mixed funds are technically not tracker funds as they do not track an index. They target a certain allocation to equities and bonds with the overall ambition of achieving positive returns for investors with reduced volatility. They do this by having higher or lower allocations to bonds and other fixed-income securities. 

These products could be perfect for investors who want to own a large, diversified portfolio of investments without having to manage the portfolio on a day-to-day basis themselves.