The Motley Fool

How to invest in index funds

UK index funds are a popular way for beginners to invest in the stock market.

Index funds and ETFs: a beginner’s guide       

When you invest in an index fund, you get the opportunity to own a wide range of different companies at an extremely low cost.  

The company managing the index fund does all the hard work for you. They’ll work out how much to invest in each company, make any adjustments along the way as required, and collect all the dividends on your behalf. 

That allows you to sit back and hopefully just enjoy the long-term gains the stock market has historically delivered.

It’s important to understand that there are many different types of index. Some cover thousands of different companies and allow you to invest on a global basis. 

Others are much more focused on a single country or type of industry and may just include a few dozen companies

UK index funds and global index funds tend to be the most popular among investors.If you want to invest in UK index funds, you’ll probably be following indices like the FTSE 100, FTSE 250 and FTSE All-Share. In America, the Dow Jones Industrial Average and the S&P 500 are examples of indices.

The numbers often indicate the number of companies within that index. For example, the FTSE 100 covers the largest 100 companies listed on the London Stock Exchange.

What is an index fund/exchange traded fund?

Index funds and exchange traded funds (ETFs) both allow you to track a stock market index for a very low cost. But they work in slightly different ways.

The price of an index fund only changes once a day. Your investing platform collects all the buy and sell orders it gets from all its customers and puts them all through at the new, updated price in one fell swoop.

ETFs are traded on the stock market so their price changes on a minute by minute basis while that market is open. You decide exactly when you want to buy and sell and the transaction takes place straight away.

One other key point to be aware of when you invest in index funds and ETFs is that investing platforms may charge you for them slightly differently.

With ETFs, you are normally charged a small commission each time you buy and sell. It’s the same amount, whatever the size of your transaction. 

With index funds, you are usually charged a small percentage of the value of your holdings each year.

As a general rule, investing in index funds is usually cheaper for smaller amounts and for those that make regular purchases. ETFs can be more cost-effective if you deal in larger amounts.

Things to know before investing in ETFs and index funds

Choose an investing platform: In order to invest in index funds, you’ll need an account with an investing platform. These allow you to buy index funds operated by many different companies.

Some companies that run index trackers themselves (e.g. Vanguard)  may offer accounts as well but this typically means you will be restricted to just their own funds.

Use ISAs and SIPPs: ISAs and Self-Invested Personal Pensions (SIPPs) are wrappers that can protect your investments from tax. Outside of these products, you may have to pay income tax on dividends received and capital tax gains on any profits.

When you start out investing, it’s easy to think you’ll never make enough to pay lots of tax. But, especially if you invest on a regular basis, your portfolio can grow a lot more quickly than you expect.

ISAs and SIPPs can save you from paying a lot of tax in the years ahead when you want to spend the money that you have invested.

Get used to ups and downs: Stock markets don’t go up in a straight line so investing can feel like a bumpy ride at times. We think it’s important to stay invested for the long haul and to resist the temptation to jump in and out at the drop of a hat. 

Start simple then branch out: With so many index funds available in the UK, it’s tempting to go racing off and buy something exotic and that has performed really well in the last few years.

We think that can be a mistake. Most investors should look at UK index funds or global index funds to start with and then maybe branch out into more specialised index funds as they get more comfortable with the process of investing.  

Pick funds that reflect your investing strategy    

Decide which index to track: There is an index fund for virtually every index in the world so you can opt for whichever one reflects the way you want to invest.

For example, you may believe Asia will become an increasingly important part of the world economy and therefore want to put more money into this region.

Or you may think that sectors like technology and healthcare are vital to our future and put more emphasis on investing in these companies instead. 

Ethical and social investing: It’s possible to get index funds that invest in an ethical and socially responsible way. One issue when you invest in UK index funds is that it may mean you are investing in lots of banks, miners, gambling, and tobacco companies.

Depending on the way you would like to invest, it’s important to look at what your index fund includes and what it excludes.

Match an index fund to your budget: Index fund charges are very competitive these days. For the most popular indices, where you may find several index funds are tracking exactly the same index, they tend to be very low. Investing in UK index funds tends to be cheapest in terms of charges.

For more specialised investments, where the underlying companies are quite small or where there is just one index fund following an index, then the charges will tend to be a little higher.

However, when you invest in index funds, you will nearly always pay much less than you would with an active fund, where you have a team of investment managers chopping and changing the holdings on a much more frequent basis.

Factor in ongoing costs 

Index funds and ETFs have very low charges. These are paid for within the fund itself, meaning that they are effectively deducted from the unit price that you pay when you buy and sell. So, you don’t have to make a direct payment to cover them. 

For this reason, the performance of an index fund will typically always slightly lag the index it’s trying to follow.

Invest via your chosen platform  

Investing platforms are the most common way people invest in index funds in the UK.

They offer index funds from all different sorts of providers and you can shelter your money from the taxman in an ISA or SIPP.

Many of them offer detailed information and research on index funds and highlight their favourites.

Investment platforms use two main charging structures. The first is based on a percentage of the money you have invested with them. The second is a flat monthly fee. Percentage-based fees are usually cheaper when you start investing while flat fees offer more value as your portfolio grows in size.

Consult an independent financial adviser

If you are unsure how to invest in UK index funds or you have a more complex financial situation, then one option is to ask an independent financial adviser to manage your investments for you.

A good adviser should be able to recommend a wide-ranging financial plan, designed to meet your long-term financial goals. They will monitor your investments and inform you if you need to make any adjustments. 

However, perhaps their most important role is to guide you through periods when there’s turbulence in the financial markets.

FAQ

What is an index fund in the UK?

An index fund is a low-cost investing vehicle that automatically tracks the returns from a particular group of investments. There are all sorts of indices and index funds available, covering pretty much every type of investment you can think of.

Which index fund is the best?

Generally, the lower cost as an index fund has the better its returns should be. But different indices will perform in different ways, depending on the type of investments that are designed to follow.

Can you lose all your money in an index fund?

As with any investment, it’s theoretically possible to lose some or all of your money. However, the risk of total loss is very low, in our opinion, if you stick to the larger index fund providers and more mainstream products.

How much does an index fund cost?

Index fund costs typically vary from 0.05% a year, UK index funds often being the cheapest, up to 0.5% for more specialised products. These costs are deducted automatically within the fund itself. Your investment platform provider may also levy an annual administration charge, as they do for all types of funds.