Both seasoned investors and beginners today are paying a lot of attention to so-called ‘index funds’. But what exactly are they? What can they be used for? What strong points do they have, and what are some of their potential downsides? In this article, we take you through everything you need to know to start investing in index funds today. To start with, a little bit of financial theory is useful to fully grasp what the purpose of index funds are and why they were created.
What is an Efficient Market?
In the 1970s statistician Eugene Fama put forward his revolutionary ideas about stock market investing – their consequences are still being felt today. Fama argued that it was almost impossible to do what every investor everywhere in the world is trying to do, to ‘beat the market’ over the long-run.
Beating the market means getting a rate of return on your investments higher than the market average for any given year. This would mean for example that if the S&P 500 rose 10% one year, an investor would aim to beat this and get more than 10%. Fama argued you might be able to do this for one year, or two years, or even several years, but no one can consistently do this over their whole investment career.
If this is true, this is a sobering thought for everyone who actively invests! Fama argued beating the market year after year was impossible because financial markets are highly ‘efficient’, and therefore prices adjust very quickly to reflect new information.
For example, if a company is doing well, it’s share price quickly adjusts up, and if a company has some sort of setback, its share price immediately adjusts down. The point is no one can realistically expect to be the first to get the info to make these decisions about what and when to buy and sell every time. Fama’s ideas are still hotly debated today, but they are relevant to this topic because they inspired the creation of index funds.
What Is An Index Fund?
An index is simply a collection of stocks which share some sort of characteristic. For example, the FTSE 100 index is made up of the 100 largest UK publicly listed companies. What happens to the value of this index is therefore an average of what happened to the value of all the shares contained by the index.
This is called ‘tracking’ the index. Sometimes the shares in an index change. For example, Royal Mail shares have rallied strongly during the pandemic, and so Royal Mail will be promoted back into the FTSE 100 later this year. Meanwhile, engineering group Renishaw looks set for demotion to the FTSE 250, the index of the next 250 largest UK companies.
So, the value of an index is a generally good reflection of what has happened to the value of the underlying shares. The value of the underlying shares is itself a generally good reflection of what is going on in the real economy (although this isn’t always the case!). Index funds are literally just funds that by all or most of the shares in a given index. This is called ‘passive investing’ because you are simply following the market rather than trying to beat it. This means that by purchasing one thing, investors can actually get exposure to a wide range of shares. This is a very cost-effective way to build a portfolio because it would be very expensive and time-consuming to go off and buy every share in the FTSE 100 for example.
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What Index Should I Track?
If you are starting to get interested in the concept of index funds, the next question is what index should I invest in? There are indexes for a huge range of stock markets and sectors of different markets by now. This is because there are many different companies that provide index funds, and they have to compete to get you to invest in their funds by offering you a great choice. The best-known providers of index funds are Vanguard, Fidelity, Blackrock, and iShares. These companies will do the hard work of buying the shares in the index for you, and any dividends that get paid to their shares will be passed along to you from the company.
This means that investors are able to express their investment philosophy by buying index funds that cover sectors or countries that they feel will perform well. For example, there are funds that track national markets like the CAC 40, which is the 40 largest French company. There are funds that track sectors, like US banks. Then there are index funds that follow global trends, like green energy and sustainability. Finally, there are even index funds that allow you to invest in other financial assets, like bonds, gold, real-estate, or commodities.
Index Fund or Exchange-Traded Fund?
This is slightly technical but it is really important to understand! Index funds and exchange-traded funds (ETFs) are both great ways to cheaply track a market index, but they work in slightly different ways. Index funds only change price once a day based on the movements in the value of the shares they hold.
On the other hand, an ETF is being traded every second the market is open, so its price will change more often. This means that while both ETFs and index funds work in the same way in terms of what shares they hold and how their price moves, it is much easier to buy into or sell out of an ETF. ETFs are literally shares in their own right, the difference being all the company behind the share does is hold shares in other companies.
There may also be slightly different charges for investing in index funds versus ETFs, but this varies from one platform to the next. Most investors interesting in this style of investing will probably chose to hold a selection of both ETFs and index funds, depending on what is on offer from the market and what specific indexes they want to track.
Where Can I Buy Index Funds/ETFs?
If you think passive investing through index funds and ETFs may be the right thing for you, the next question is where to go to do this? There are loads of great platforms out there, all with their own accounts letting you dive into the deep pool of index funds and ETFs.
Some respected platforms include eToro, Hargreaves Lansdown, and Charles Schwab. These platforms will allow you to hold your index funds and ETFs in an ISA or a SIPP account. The advantage of these accounts is that they shield you from tax on your investments, both on dividends paid to you and capital gains from the value rising. Although the threshold at which you pay tax on investments is quite high, the miracle of compound interest in low-cost funds means over time you may well reach that threshold!
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What Is Your Investment Philosophy?
This last question is the most interesting one for you to answer, and also the most important! As we have said, the universe of index funds and ETFs is now so vast and so diverse, you can find a fund that reflects any possible position you may have on stock markets around the world. This means that the range of choices you have as a passive investor is enormous.
The first thing to consider, is where in the world do you want your money to go? Do you prefer the steady return available in developed Western markets, or do you want to track more risky but potentially higher return indexes following emerging markets? China and Asia in general will inevitably become a bigger part of the world economy over the next decades, but when is the right time to invest in such unpredictable markets is a hard question to answer! Equally difficult is how to do this to best capture the growth potential.
The recent Chinese government crackdown on their tech sector has seen shares in tech giants like Tencent and Alibaba tumble as a result. As always, a bit more reward comes at the price of a bit more risk.
It is possible to express a broader investment philosophy via your choice of ETFs and index funds. For example, there are now many funds that offer so-called ESG investing. ESG stands for ‘environmental, social and governance’, and is a way of saying the investments are made into sustainable companies with green and ethical concerns at the heart of their business models. This is an issue especially relevant for the UK.
The FTSE 100 has more than its fair share of miners, banks who have had corruption scandals, gambling firms, and tobacco conglomerates in it! The investment platform you choose to use to buy and sell funds will offer and range of tools and forums where investment ideas and tips are shared. This resource should be useful in further clarifying your ideas on where you’d like your money to end up.
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What Are the Likely Costs?
Bear in mind that the more specific your index fund is, the more the charges will be. This is because there is a bit more work to be done by the company making the fund. For example, if it is ESG screened, then the company has to check each company in an index in a detailed way to see if it lives up to the ESG concepts the fund is arranged around.
If you just want to track a major global index, then the costs will likely be very low, for example below 0.01%. However, even with more costly index funds, they will always be cheaper than actively managed funds. This is a big part of their appeal to ‘buy and hold’ long-term investors! The platform you invest through will deduct the fees directly from your investment, so there isn’t any need to pay separately.
Should I Consult an Independent Financial Adviser?
For some investors who are still unsure on how they want to proceed, it may be worth asking an independent financial adviser to manage your investments for you. This will come at a charge, of course, but is a route popular with those who don’t want to put the time or effort into selecting their own investments.
A good adviser will be able to recommend a wide range of financial plans, and you can then pick which best suits your needs and will help you meet your long-term financial goals. In addition to this, they will monitor your investments and inform you if you need to make any adjustments.
This approach suits the very risk-averse, although your returns will be lower due to the fees you will be paying to the adviser. This would go against the general idea of index funds, which really is that such paid for advice is unnecessary for those who are happy to earn the market average each year.
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