The best low cost index funds to buy now

Index funds continue to outperform active funds, as data shows that investors are still putting their money into these low cost investment vehicles. This continues index funds’ momentum as the top funds for investors compared to actively-managed counterparts.

It was a big moment for passive funds at the start of this year when the amount of money held in index funds and exchange traded funds (ETFs) in the US - the world’s biggest investment market - surpassed that of actively managed funds for the first time.

According to data released by Morningstar, passive mutual funds and ETFs in the US - a barometer for the rest of the world - held $13.3 trillion in assets at the beginning of 2024, while active ETFs and mutual funds had just over $13.2 trillion.

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In the UK, the latest figures from the Investment Association show that, while most UK equity funds saw net outflows during October, index tracking funds saw net retail sales of £880 million. While this marked their lowest rate of inflows in a year, it highlights the relative appeal of low-cost index funds compared to actively managed funds.

Miranda Seath, director of market insight and fund sectors at the Investment Association, tells Moneyweek that “we’ve seen real momentum behind sales into trackers” over the past year.

The much-anticipated shift in the balance of power had been many years in the making and the swap has awoken fund investors to the significant benefits of low-cost index investing.

What is passive investing?

In simple terms, passive investing means the securities held in your fund are not chosen by a portfolio manager, which can make the cost of investing drastically cheaper.

Passive or index funds instead buy a basket of assets that try to mirror what the stock market is doing instead of trying to beat it. Using much more technical language the CFA Institute, the association of investment professionals, describes it as so: “Passive investing refers to any rules-based, transparent, and investable strategy that does not involve identifying mispriced individual securities.”

If you are a passive investor, you are also in it for the long haul. Passive investors limit the amount of buying and selling within their portfolios, which is also what makes it such a cost-effective way to invest.

An obvious example of a passive approach is the purchase of an index fund that follows a major index like the FTSE 100 in the UK and the S&P 500 in the US.

The advantages of passive vs active investing

On paper, being an active investor beating the market seems like the best way to invest. After all, isn’t that how celebrity investors like Michael Burry and Warren Buffett made their fortunes?

In reality, beating the market is difficult and the majority of active funds not only fail to do so but also significantly underperform. That, coupled with the fact the fees on active funds are almost always higher, means they can be an unadvisable way to invest in the stock market.

Indeed, according to a report from the London Stock Exchange Group, 64.5% of actively managed funds failed to beat their benchmark indices over the 12 months to the end of March this year. The numbers showed investors in 9,036 active funds were worse off than if they had invested their savings in an index tracker.

The report stated that much of this underperformance was caused by the high fees.

“Historically, trackers start to become a significant part of our data in terms of flows in about 2018,” explains Seath. Part of the background to this is the Retail Distribution Review which came into effect in 2013 and, among other things, removed commission payments to advisers and platforms from product providers.

Prior to this, says Seath, “commission was a big driver of fund recommendation”, meaning “it wasn’t really economically viable to run low cost indexing strategies because they didn’t want to pay that type of commission.

“It took about four years of that momentum to propel flows into trackers,” she explains. “They’ve been remarkably consistent, but also building, since then.”

Interestingly, Investment Association show that both index funds and active funds tend to see inflows during market upturns. During downturns, however, active funds tend to see outflows – but index funds, in general, don’t.

The reasons for this aren’t clear. Passive funds follow the markets, so when the markets go down, they do as well. The cost advantages of index funds compared to active funds might well be part of the explanation.

“If investors can control anything, they can control the price they want to pay to access different assets,” says Seath. Additionally, while active funds can potentially outperform the benchmark, they can also underperform it (and as above, high fees can compound this.

Seath believes, then, that there is also a degree of security offered to investors through tracker funds during a downturn; they may incur losses, but these won’t be greater than the wider market.

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.

Low costs are key, of course. Every penny you pay in management fees is a penny that does not 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.

However, costs aren’t the only factor to consider. For example, it is 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.

Further, Seath says there are other important characteristics of funds that investors should pay attention to before buying.

“Whenever you look at a fund, you have to look at what it’s suggesting its investment objective is,” she says. “It will tell you what kind of risk rating it has. There’s lots of information that investors can find out about the behaviour of the fund, how volatile its return performance might be.”

What are the different types of index funds?

Tracker funds typically come in one of two main types: open-ended funds (Oeics), which are not traded on the stock market, 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. That means 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.

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).

The best low cost index funds to buy now

Here is a selection (which is far from exhaustive) of some 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.

Source: MoneyWeek research