Index Funds Explained
By Mike Narouei, Content Producer at Boring Money
10 Sep, 2018
Index fund is a fancy name for a simple idea. They go by a number of fancy names, in fact – passive, exchange traded funds (ETFs), trackers. At heart, they all do the same thing: instead of some pointy-headed person picking the shares that go into the fund, they simply replicate an index.
Index funds explained
That’s a financial index like the FTSE or the S&P 500, mind you – nothing to do with the helpful list at the back of a reference book.
So what’s a financial index? An index is a just a group of shares. Usually, they are grouped by size. The FTSE 100 index, for example, is the 100 largest companies in the UK stock market. The S&P 500 index is the same in the US. However, there are indices that look at criteria other than size – the Nasdaq, for example, focuses in on the leading technology companies.
Index funds just track these indices up and down. They may no call on whether one share is better than another. If it’s in the index, they’re invested. The alternative is an ‘active’ fund, where a fund manager aims to use their experience and skill to find the best investments. An active fund manager by definition thinks he or she is smarter than the average investor. A clever clogs. They think they can spot a bargain. Spot the dog before others. Identify the region that is about to go belly-up. The problem with this approach is that you take a risk on whether the fund manager gets it right or not, and you also pay a bit more.
An active fund will usually charge around 75p for every £100 you entrust to them. An index or passive fund, in contrast, will only cost you around 12-17p for every £100 you entrust to them and ETFs may be even cheaper. This may not sound a lot, but it can add up over time. At 5% growth, a £20,000 investment would grow to £54,250 over 20 years. Knocking 0.5% off for costs would reduce this to £49,100. More than just a few jangling pennies.
The active manager will argue that not only can they decide which companies are good and bad, focusing on the good ones and dismissing the bad ones, they can also pick smaller emerging companies that aren’t in the index. This type of company can grow very fast and give your portfolio a boost over and above the index performance. Someone looking at what to put in their stocks and shares Isa will need to decide whether they want to take that risk.
So what does all this mean?
Some very clever people have made compelling arguments on both sides about whether passive or active is the ‘best’ investment option. Debate can be animated to say the least and there is regular fist-shaking on the topic in the press. Every individual will come to his or her own conclusion.
For what it’s worth, Boring Money’s take on this is that investment is a little like driving. We all think that we are good drivers and better than the average driver. Statistically though, this cannot be true. (Nonetheless, I am clearly better than most. I mean I really am. Truly. It’s not my fault they make kerbs so high.)
And it’s the same with active managers. Some of them are brilliant at what they do and really do earn their fees, making their investors lots of money and far in excess of what they’d receive from the index. Yes, you pay more, but you make more. Fair enough.
Problem is they are not all like that, and sometimes it’s quite difficult to pick the wheat from the chaff (and there’s a lot of chaff). The painful bit is when you pick a smarty -pants who frankly ain’t so smart and you pay a bit more… and make a whole lot less. Double whammy.
Index funds take out part of the decision-making process, which – let’s face it – is complicated enough as it is. They won’t take big bites out of your savings in fees and they can be an easy-ish way for less-confident investors to get started.
In Active Land, there is a core bunch of about 100 brands all shouting from the rooftops in that quiet unassuming City way about how they are smarter than the rest. More active than the rest. Bigger than the rest. King Kong stuff. And it’s very difficult to know which one to choose.
In Passive Land, there are three main brands out there today with passive funds. BlackRock, L&G and Vanguard. All whopping great big brands and (I’m going to whisper this because they get very upset but…) I don’t think there is really much difference at all between them for us normal retail investors. Shhhh! So choosing often comes down to price.
So what should I do?
Going with a passive fund or ETF doesn’t completely absolve you of choice. You will still have to decide where you want to invest – which country, which sector and so on. You will also need to decide whether you want to be all passive or include some active funds around the edges. (This is known as a ‘core/satellite’ approach if you want the City lingo). A popular way to manage a stocks and shares Isa is to hold the main bit of your portfolio in passive funds, with a few active funds scattered around the edges to ‘pimp their ride’.
If you really haven’t got the foggiest, and I’m making you feel weak, have a look at Vanguard’s LifeStrategy or BlackRock Consensus funds or Legal & General and see what you think. These are a low-cost passive range and the fund managers will choose the different markets to invest in. You just need to decide what the split between bonds and equities should be (how ‘spicy’ your investment should be) – and they help you think about this. So there are a lot less decisions involved along the way for you to make.
Where to buy them?
The last thing you want to do is to buy a super-cheap passive fund on a mega-expensive platform. All the funds mentioned above are available on platforms, but you need to check how much you’re paying in costs as well. Have a nosey at our Investment Platforms page to see who we rate. If you only want the fund and nothing else, it is often cheapest to buy direct from the fund group where possible.
Fidelity has some passive funds available on their platform and – with a platform fee of 0.35% – this can make for a low-cost way to stick a toe in the investment water. Again, if you’re feeling a bit bamboozled, look at Fidelity’s Pathfinder Foundation Range. This is a low-cost passive range of funds where the people at Fidelity have made the decisions about bonds vs shares as well as what funds to buy.
‘ETFs’ or Exchange Traded Funds are a type of index fund, only they are bought like shares. This means that you may pay a one-off charge every time you buy and sell them (funds are typically free to buy and sell). This makes them a poor choice for regular savings, though some platforms have got wise to this and have amended their charging structure.
ETFs are super-cheap, but you’ll need to get them through a platform that offers share trading – The Share Centre, Barclays Stockbrokers, Hargreaves Lansdown or TD Direct Investing. If you’re investing small amounts, look for a platform which charges a % fee, not a fixed £ fee, and stick with funds. Charles Stanley Direct, Bestinvest, Fidelity and Hargreaves Lansdown are examples. If you’ve got mega bucks, check out Alliance Trust Savings or Interactive Investor because their fixed £ fees look compelling.
I hope that’s been a useful introduction to the world of passive investing. I think it can be simpler than some people make out. Index funds can be a low cost, straightforward choice for all types of investors. You know what you’re getting. You can think it can be simpler than some people make out. But do make sure that you are investing for the long-term. The performance of the FTSE 100 is widely published so if you’ve got a FTSE 100 tracker, you’ll know what’s happening with it and that can be reassuring. You still need to do all the usual investment stuff – look long term, ride out the ups and downs and so on.