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How to invest in index funds

Index funds are a popular way for beginners to invest in the stock market without the risk of picking a stock that doesn’t do well.

What does an index fund do?

A stock market index is a measure of a specific section of the stock market. In the UK, the best-known indices are 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.

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The purpose of an index fund is to track a specific index. So a FTSE 100 fund tracks the top 100 UK stocks on the London Stock Exchange.

Unlike actively managed funds, the aim of an index fund is to passively track the market and match its performance, rather than try to beat it. A minimum of a 10-year investment is usually recommended when investing in one.

Exchange-traded funds (ETFs), are a popular example of index/tracker funds, and they offer small-time investors the opportunity to own a diverse basket of stocks, at relatively low risk to their money.

How do I buy an index fund?

Choose a broker: Many brokers will give you the option to open a fund and share account, a Stocks and Shares ISA, Lifetime ISA (LISA) or Self-Invested Personal Pension (SIPP). From there you can choose from a wide selection of funds and build your own portfolio in a DIY manner, with complete control over your selection.

Other factors you might want to consider in a broker account are its ease of use, research tools, introductory offers and of course, fees. There could be a platform fee, dealing fees, fund charges and possibly overseas dealing charges. All of these need to be taken into consideration, along with how frequently you intend to trade.

Decide which index to track: There is virtually an index fund for every index in the world so you can opt for whichever one appeals to your personality. Apart from the best-known FTSE 100 and FTSE 250 indices, you may be interested in the FTSE All-World Emerging Index, FTSE USA Index or the FTSE All-World Japan Index, to name a few.

Match an index fund to your budget: An index fund usually requires a lump sum investment to get started. It will also likely incur the ongoing cost of a small percentage of the value of the fund. These minimum deposits and ongoing costs vary from broker to broker and should be compared before committing to one.

The pros and cons of index funds

Pros:

  • Liquid (shares are easier to sell)
  • Tax-efficient
  • Passively managed
  • Relatively cheap

Cons:

  • Possible exposure to companies you don’t like (big pharma, oil, arms manufacturers)
  • Gains are low
  • Volatile during a recession
  • Exposure to overvalued stocks
  • Level of risk is debatable.

As the risk with index funds is traditionally presumed to be low, it stands to reason that the returns are also not spectacular. It’s a popular investment for those seeking something simple and hands-off. Index funds are great when the stock market is doing well, but you can lose money during a bear market and hedge fund manager Michael Burry recently warned they could be a disaster waiting to happen. He prefers to invest in small-cap stocks because they are often under-represented in passive funds.

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.