What is an index fund and is it a worthwhile investment? You may have already come across indexes such as the S&P 500 index or the FTSE 100 without realising what they are.
I’m going to explain everything you need to know about index funds. I’ll focus on why they’re an important investing tool, and whether they might be a good investment for you.
What is an index?
The easiest way to think of an index is simply as a list. A list focused on a particular category. This could be a list of companies within a country or an industry. It could also be a list of a certain type of assets, like bonds.
Having an index makes it nice and easy to be able to track the performance of that list.
Compiling multiple companies or assets into a simple list also creates the opportunity for a straightforward investment. This is known as an index fund.
What is an index fund?
An index fund allows you to invest in every company within one of these lists.
When you invest, a portion of your invested capital goes towards each and every company or asset within that index.
How do investors use these funds?
Index funds are a popular choice for passive investors who want diversification without the hassle of maintaining a diversified portfolio.
Investing in a fund can be an automatic way of ensuring you’re diversifying without having to pick all the stocks. However, not all index funds are the same.
Just because you invest in an index fund doesn’t necessarily mean that your portfolio is properly diversified. Some funds are very specialised or concentrated.
The risks of index funds
Index funds are often viewed as a low-risk form of investing, but this isn’t always the case.
Because they can focus on almost any area, they’re all very different. Some will carry much more risk than others, so it’s still important to research a fund properly before investing.
It’s very unlikely that the value of some of the main indexes like the S&P 500 index or FTSE 100 would drop to zero. This is because these indexes track some of the biggest companies in the US and the UK respectively. Every time a company on the list goes bust, a new one replaces them. So they’re self-cleansing.
However, if you invested in a tech-focused index fund during the 1990s, your fund’s value likely took a dramatic downturn due to the dot-com bubble. Similarly, if you invested in a fund tracking Japanese companies, you probably saw little to no growth in the 30 years that followed.
Here are a few more of the risks of passive investing.
What are some of the most popular funds?
You’ve probably heard of some of the most popular indexes, even just in passing. Some of the most sought-after funds track these and include:
- S&P 500 index
- Dow Jones Industrial Average
- Nasdaq Composite
- FTSE 100
- FTSE 250
Some index funds will be slight variations of the main indexes listed above. An example would be a fund covering the S&P 500 index but concentrating on companies paying dividends.
Also rising in popularity are ESG funds. These can be very similar to a key index but they omit businesses whose activities can be perceived as harmful.
What kind of investors suit these funds?
Broad index funds are often good for investing beginners or investors preferring a hands-off approach.
This is because they don’t require any maintenance. All of your investments are picked for you and there’s no need for you to rebalance your portfolio. It’s all done automatically.
Specialised funds can also be a useful tool for seasoned investors. They offer exposure to a particular niche market.
Overall, index funds are a popular choice for those looking for steady growth over the long term. Making monthly purchases of a fund allows dollar-cost averaging and the building of wealth over time using compound interest.
How to invest in an index fund
There are two simple ways to do this:
- Find an index or fund that you want to invest in and then find a share dealing account that will give you access.
- If you already use a trading platform, see what funds are available. Research their offerings and choose a suitable fund.
Either way, it’s really important to try and use a stocks and shares ISA so that your index fund investments can grow as much as possible with minimal tax obligations.