Index funds are gaining popularity for their simplicity and low cost of diversifying an investment portfolio. As a reminder, these can come in the form of a mutual fund or ETF and are designed to track the performance of a specified benchmark stock market index.

It’s a form of passive investing suitable for long-term buy-and-hold investors. The investment fund pools capital from different investors and then invests the money into the constituent companies of an index like the FTSE 100 or S&P 500.

As indices typically contain hundreds or sometimes even thousands of stocks, an index fund is a highly diversified investment vehicle that can reduce the risk profile of an investment portfolio.

In most cases, the fund manager of an index tracker fund is actually an automated trading algorithm rather than a human being. As such, the annual management fees are typically exceptionally low.

How to invest in an index fund?

Buying and selling shares in an index fund is a relatively straightforward process, even for novice investors. Here are the main steps involved:

1. Open a brokerage account

In order to access and invest in the financial markets, an investor requires a brokerage account. These are sometimes referred to as investment accounts.

There are various types of brokerage accounts for investors to choose from, each with its own advantages and disadvantages. One may be more suitable than another, depending on the objectives and personal circumstances of the individual.

• Standard Account – This is the most common type of investment account. Investors deposit capital which can then be used to invest in an array of financial products, including stocks, bonds, mutual funds, trusts, and ETFs. In the United Kingdom, all capital gains and dividends received through investments in a standard trading account are subject to tax.
• Employer-Sponsored Retirement Account – This is a special investment account with certain tax benefits. However, withdrawals from this account are limited until investors reach a certain age. They are designed to be a saving instrument for pensions. The most common type of employer-sponsored retirement account in the United States is a 401(k).
• Stocks and Shares ISA – This is a special tax-efficient investment account for British investors only. All capital gains and dividends received from investments within a Stocks and Shares ISA are tax-free. However, investors are limited to depositing a maximum of £20,000 per year.
• Self-Invested Personal Pension (SIPP) Account – This is a special tax-deferred investment account for British investors only. Capital gains and dividends received from investments are protected from tax. However, investors cannot withdraw any funds until reaching the age of 55 (57 from 2028). When funds are taken out, they are taxed as regular income.

2. Select an index to track

There are over 5,000 indices worldwide, each tracking a different collection of stocks, sectors, commodities, and currencies. Each one generates a different level of average returns and is exposed to varying levels of risk and volatility.

Before selecting an index fund to buy shares in, investors need to decide which index they want to track. The decision should be based on their previously outlined time horizon, risk tolerance, and investment goals.

On the London Stock Exchange, there are three flagship indices that index investors commonly track.

• FTSE 100 Index – This index comprises the largest 100 multinational blue-chip companies listed in the United Kingdom based on market capitalisation. The index is generally less volatile than other UK-listed indices, generating most of its historical returns through dividends. However, it is still vulnerable to stock market fluctuations and price swings.
• FTSE 250 Index – This index consists of the 101st to 251st largest listed companies in the United Kingdom based on market capitalisation. The vast majority of its constituent companies are mid-cap stocks which offer greater growth potential than the companies found in the FTSE 100. However, the smaller scale of these enterprises also means greater share price volatility, introducing additional risk to investors seeking to track the index. 
• FTSE 350 Index – This index combines the FTSE 100 and FTSE 250 companies granting investors exposure to both large-cap and mid-cap stocks. The FTSE 350 isn’t followed as much as the FTSE 100 or FTSE 250, as most investors prefer to stick with either a defensive or aggressive investment strategy.

In the United States, the three flagship indices that index investors mostly follow are:

• S&P 500 – Comprises of the 500 largest companies listed on US stock exchanges. Note that because some of the companies have multiple share classes, the index actually consists of 503 stocks issued by 500 businesses. The vast collection of enterprises covers almost every industry and subsector, making it a popular proxy to measure the performance of the US economy.
• Dow Jones Industrial Average – This index contains 30 prominent blue-chip stocks listed in the United States. It’s more commonly referred to as Dow Jones, Dow 30, or just “The Dow”.
• Nasdaq 100 – This index contains a basket of the 102 latest and most actively traded stocks listed on the Nasdaq Stock Exchange. Despite having companies across a broad range of sectors, most of the businesses found within the Nasdaq 100 are based in the technology industry, which exposes the index to increased volatility and cyclical trends.

3. Pick an index fund

After selecting which stock market index to track, an investor must select which fund to invest in. There are often multiple funds tracking the same index. So, how can an investor determine which one is the best index fund?

When picking a tracker fund, several factors need to be considered.

• Tracking Index – Investors should verify that the index fund actually tracks the previously selected index. While it is usually obvious from the name, some funds can be more obscure and need to be checked before purchasing any shares.
• Expense Ratio – While typically low cost, Index funds still incur annual management fees. And some even charge entry fees when first buying shares as well as exit fees when selling shares. The expense ratio is the combination of all costs, which adversely affects the overall return on investment. On average, the expense ratio of a passive fund typically lies between 0.05% and 0.15%. Generally speaking, investors should focus on the funds that charge the lowest fees.
• Minimum Investment Requirements – Some index funds require investors to purchase a minimum amount of shares. This is typically more common among certain mutual funds rather than ETFs. Nevertheless, minimum investment requirements could create barriers to entry for lower net-worth investors.
• Dividends – All shareholders in an index fund are entitled to receive dividends from the companies inside the fund’s investment portfolio. However, depending on the dividend policy, any received income may be automatically reinvested into the fund’s portfolio rather than distributed to shareholders’ investment accounts. This type of dividend policy is more commonly referred to as accumulation.

4. Buy shares in the index fund

With a brokerage account opened and funded and the stock market index and fund selected, investors can now buy shares. However, the time these trades are executed depends on the type of index fund being purchased.

Transactions in an index mutual fund will be completed at the end of the current trading day. Transactions in an index ETF will be completed immediately while the stock market remains open.

Can I lose money from index funds?

Index funds mimic the performance of stock market indices, which are known for generating an upward trend over long periods. However, no investment is without risks, and index funds are no exception.

The risk associated with index tracker funds ultimately depends on which index is being tracked. In other words, one index fund can be riskier than another. But there are additional risk factors to consider beyond price volatility.

• Tracking Errors – Over long time periods, an index fund’s performance can slowly drift away from the performance of the index it’s tracking. These tracking errors can arise as a result of the annual management fees and other unexpected costs incurred by the fund.
• No Flexibility – An index fund will strictly contain all the companies within the specific index it is tracking. Therefore, investors may end up owning shares in businesses that do not align with their ethical or moral principles.
• Illiquidity – It may be difficult to match buyers and sellers for some niche index funds. As such, selling shares in an index fund at the quoted market price could prove challenging resulting in wider bid-ask spreads that will adversely affect the return on investment. When investing in index funds that track mainstream indices, this problem rarely arises.

Alternative investments to index funds

Index tracker funds are one of many financial instruments available to investors to expand their net wealth.

Some popular alternatives include:

• Stocks – Invest directly into publically traded companies.
• Bonds – Invest directly into buying debt from companies or government institutions.
• Exchange Traded Fund (ETF) – Invest through a cost-effective investment vehicle to gain exposure to a wide range of financial assets.
• Mutual Fund – Invest in a basket of financial securities and assets to grow shareholder capital either in line with a benchmark index or attempting to beat a benchmark index.
• Real Estate – Invest in property with a traditional mortgage or through various real-estate financial instruments such as a real estate investment trust (REIT).
• Private Equity – Invest in shares of companies within the private sector. This is typically only available for high-wealth individuals or institutional investors.
• Hedge Funds – Invest capital into a fund that uses complex financial instruments, such as derivatives, to achieve market-beating returns.
• Venture Capital – Invest in start-up businesses. This is exceptionally high risk but, if successful, could generate ginormous returns. . This is typically only available for high-wealth individuals or institutional investors.

The bottom line

Index funds are a passive investment and a well-established method to quickly and cheaply diversify an investment portfolio. By leveraging the power of index investing, investors can grow their wealth in the long term while not having to spend time and effort researching and picking individual stocks.

However, by relying solely on index investing, an investor’s portfolio will never achieve market-beating investment returns.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.