What is an index fund?

We outline everything you need to know about index funds, from what they are and how to buy them, to the things to consider before you do so.

Stock index display in Tokyo
Index funds copy the composition of an index, such as the FTSE 100 or the Nasdaq
(Image credit: © James Matsumoto / Getty Images)

Index and tracker funds are a multi-trillion dollar market, letting investors replicate the performance of a particular market or asset class - but how do they work?

It may seem like a new concept but index funds have actually been around for decades.

They have entered the limelight recently as investors focus on value for money, fees and fund performance.

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The first ever index fund was introduced by John Bogle, founder of the Vanguard Group, in 1975. Vanguard is now one of the largest investment firms - the Vanguard 500 fund still tracks the returns of the S&P 500 nearly 50 years later.

Bogle’s ambition was to make investing easier and more cost-effective for the average investor, saving them the hassle of picking out individual stocks and allowing them to (ideally) profit from all of the stocks in an index at a low cost.

Plenty of other asset managers such as Blackrock, Fidelity and Invesco now also offer index funds.

There are also robo-wealth managers who will build a diversified portfolio of passive funds for you based on your attitude to risk.

This takes some of the research and monitoring out of your hands but can be a good way of investing in index funds if you are happy for someone else to manage your portfolio.

What is an index fund?

Index funds copy the composition of an index, such as the FTSE 100 or the S&P 500, aiming to match the index’s return. So an FTSE 100 index fund would copy the stocks that make up the FTSE 100 and in theory deliver the same returns.

Index funds, also known as tracker funds, are a type of passive fund. This means they do not have an active manager picking out stocks and attempting to outperform the market, and therefore charge much lower fees.

There are two types of index funds: traditional open-ended investment companies (OEICs) and exchange traded funds (ETFs).

ETFs, as their name would suggest, are traded on an exchange and can be bought and sold like a stock. OEICs don’t trade on an exchange

Because index funds track a wide variety of stocks, they are a good way to diversify your portfolio. They also don’t tend to change their underlying holdings much – they only change when the stocks in the underlying index change.

This stability, combined with their low fees and diversification, means they make for an appealing investment.

You can buy an index fund through fund platforms and brokers, or directly with the company that offers the fund.

What to keep in mind when investing in an index fund

OEICS and ETFS have different fee structures, which you should consider when deciding which one to buy.

Index funds hold all of the stocks from the index they’re tracking. When investing in one, you want to look for as low a “tracking error” as possible.

The tracking error is the difference between the index’s performance and the performance of the fund. The index fund’s aim is to match the index, so significant overperformance (or underperformance) should raise a red flag.

You should also keep costs in mind. Low fees are part of index funds’ appeal, especially when compared to active funds. Many providers offer index funds and there are many trackers for every stock exchange, so make sure you shop around to secure the best low-cost index fund.

Also, the fees will eat into your return. However, as we’ve said, index-fund fees tend to be quite low, so you’re not going to experience a massive difference.

Index funds track the market regardless of how it’s performing. This might spook investors in market turbulence, but it’s always worth riding that out and waiting for the market to stabilise again before making decisions about selling.

How do index funds compare to active funds?

Actively managed funds justify their higher fees because fund manager and their teams are paid to make strategic decisions about their portfolio. These include what stocks to buy and sell and when to do so.

Index fund managers copy their underlying index and so make far fewer changes, which means operating fees are much lower.

While actively managed funds attempt to beat the market, they rarely ever do so for extended periods of time. This makes it hard to justify the hefty fees, and it’s been one of the main drivers behind index funds’ increase in popularity.

Nicole García Mérida

Nic studied for a BA in journalism at Cardiff University, and has an MA in magazine journalism from City University. She joined MoneyWeek in 2019.