The popularity of index funds is on the rise. It is easy to see why, as they seem to be a great way to invest.
When buying an individual stock can sometimes rack up a fee of £10, the barriers to buying an index fund are lower. The fee is usually charged as a percentage of what is held in the fund. This amount can be very low, often around 0.1%.
It is common to be able to buy into an index fund with as little as £100. In our example above, if you bought an individual share for £100, a £10 fee would mean you’re 10% down on your investment already.
An index fund often also allows the investor to buy into a ready-made, diversified portfolio.
As with all things investing, when buying index funds there is still an important choice to make.
Although it may seem like a percentage point here or there, maximising returns – however small – can make a real difference to an investor’s success over the long-term. This is due to the powerful force of compound interest.
Therefore, when buying into an index fund, it’s important that we make the decision with the same due diligence we would when picking an individual share.
Investors may commonly choose an index fund that aims to replicate the returns of the FTSE 100.
It is easy to see why: the index is made up of the UK’s top 100 listed companies. Its components include businesses involved in industries such as tech, mining, consumables, and financials.
A large percentage of the revenues of the index emanate from outside of the UK. This may be seen as a benefit to investors who are seeking an element of international diversification.
On the face of it, the index sounds great. But investors may want to look at an alternative.
The FTSE 250 sits below the FTSE 100, and is made up of the next 250 largest listed companies in the UK.
As you might expect, the component parts of the FTSE 250 also include businesses from a spread of different industries.
As the FTSE 250 is made up of slightly smaller companies, and with a more domestic focus, I believe that in the future it might have more room than the FTSE 100 to grow.
Let’s take a look at the historic data.
FTSE 100 vs FTSE 250
History may not repeat itself, but I think it is helpful to see how the two indices have performed in the past.
Harvey Jones has pointed out that while the FTSE 100 has delivered a total return over five years of 32.3%, the FTSE 250 has returned 48.9% over the same period. Over the long term, this could make a huge difference to an investor’s prosperity.
For long-term growth, it could be the case that the FTSE 250 offers the best prospects. But the beauty of index fund investing is that you can build a portfolio of index funds. It may be that you chose to invest in both types of index funds. After all, you don’t want to have all of your eggs in one basket.
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T Sligo has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.