Investing: what is an index fund?
Index funds turn indices, which have no physical value, into something you can invest in by mirroring their contents. The two main types of index funds are index mutual funds and index ETFs. To find out more about how you can invest in index funds, read on.
Indices, such as the FTSE 100, the Dow Jones or the S&P 500, are some of the most talked about elements of the stock market, dominating headlines when they rise and fall.
They are used as indicators of the health of the economy and can act as benchmarks with which to compare your own investments.
However, you cannot buy or sell indices themselves.
You could try to recreate an index as an individual investor, buying shares in all of the components that make up the index you are interested in. But this could cost a lot of money since indices can have hundreds, or even thousands, of constituents.
This is where index funds come in. They do the work for you, building a replica of an index that you can then buy and sell through your brokerage account.
Read on to discover the different ways in which you can invest in an index fund.
» MORE: What is an index?
How do index funds work?
An index fund is a way of turning an index, which has no physical value, into something you can invest in.
The fund will aim to mirror a specific index as closely as possible by either buying all, or a representative sample, of the assets that make up an index in the same proportion as they are found on the index.
When buying an index fund, an investor can therefore quickly diversify their investments within the index they are following.
Index funds are often referred to as a ‘passive’ investment strategy. Rather than trying to actively ‘beat the market’ by hand-picking a portfolio, the aim of an index fund is to match the returns of a pre-established segment of the financial market.
This segment will often be a benchmark stock index, such as the Dow Jones or S&P 500.
For example, a FTSE 100 index fund would contain shares in each of the 100 companies that constitute the index, in amounts that reflect their weighting.
If the FTSE 100 then rose 5.8% in a year – roughly its average annual price return between 1984 and 2019 – your return on your index fund would also be around 5.8%, minus fees.
If the FTSE were to fall by a certain amount in a year, the value of your FTSE 100 index fund would also decrease by a similar amount.
» MORE: What is the FTSE 100?
Investing in index funds
There are two main ways of investing in index funds: through an index mutual fund or via an index ETF (exchange-traded fund).
Although they are different products, at their core, index mutual funds and index ETFs largely function in the same way.
Both are portfolios structured to match a specific index. This means they hold the assets that make up the index in amounts dictated by that index’s weighting.
These portfolios are overseen by professional managers but, because they are passive funds, they often have lower expense ratios – i.e. management and admin fees – than actively managed funds.
» MORE: What is an ETF?
ETFs vs index mutual funds
While they are similar in many ways, there are a few important differences to consider before choosing to invest in either an index mutual fund or an index ETF. The main differences are:
Where you can buy and sell them
Shares in index mutual funds can be bought directly from the mutual fund company or through a broker. The share represents your part-ownership of the fund and any money it makes. These shares are redeemable, meaning they can be sold back to the mutual fund.
In contrast, a share in an index ETF operates like a share in a company listed on the stock exchange. And since these ETF shares can be traded between investors, they can only be bought and sold through a broker or investment platform.
When you can buy and sell them
The price of an index mutual fund is calculated at the end of the day. That means, regardless of when you place your order, they can only be bought and sold at the end of the trading session. Therefore index mutual funds may be appropriate for more hands-off, long-term investors who are content to sit and wait.
ETFs, meanwhile, are freely available to trade on the stock market, just like any other share. This means you can buy and sell them throughout the day based on real-time pricing, potentially making them appealing for investors who are actively trading on the stock market.
Since you can buy shares in an ETF, your initial investment can be as little as the cost of one share, or, in some cases, even a fraction of a share.
The initial minimum investment for index mutual funds, on the other hand, varies from fund to fund. Some have zero minimum investment, while others can cost thousands of pounds.
Both ETFs and index mutual funds will be subject to ongoing costs, such as commission fees and expense ratios.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
Image source: Getty Images
Connor is a writer and spokesperson for NerdWallet. Previously at Spreadex, his market commentary has been quoted in the likes of the BBC, The Guardian, Evening Standard, Reuters and The Independent. Read more